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Chapter 2

THE GLOBAL MACROECONOMIC ENVIRONMENT

LEARNING OBJECTIVES

  • Discuss potential effects of the growth of regional blocs on global free trade.
  • Explain the differences and similarities between a free trade area, a customs union, a common market, an economic union and a political union.
  • Describe the static and dynamic benefits of regional economic integration as well as the supply-side led benefits that will accrue to member countries.
  • Describe the key features of the Uruguay Round of the General Agreement on Tariffs and Trade and the World Trade Organization and their implications for the conduct of business between member countries.
  • Discuss the significance of the World Trade Organization to international trade.
  • Describe the important characteristics of the North American Free Trade Agreement and the European Union.
  • Discuss the ways in which the major regional economic agreements can be expected to improve business opportunities, and problems associated with their implementation.
  • Examine the phenomenon of globalization and its meaning.
  • Evaluate the significance of country-specific economic features and competitiveness rankings to international companies.

TOPICS

A new global economy

The General Agreement on Tariffs and Trade and the World Trade Organization

What GATT left undone

The World Trade Organization

Settlement of disputes by the WTO

Country-level economic integration

The effects of economic integration

Static effects of economic integration

Dynamic effects of economic integration

Supply-side economics effects

Major regional economic agreement initiatives

The North American Free Trade Agreement (NAFTA)

Association of Southeast Asian Nations (ASEAN)

MERCOSUR

The European Union (EU)

Will regional trade blocs promote global free trade?

Globalization

Specific drivers of globalization

The two sides of globalization

Country-specific economic environments and country competitiveness

LECTURE OUTLINE

Opening Case

Trend Micro Inc. is a unique company.This antivirus-software company has spread its top executives, engineers, and support staff around the world to improve its response to new threats.The company’s financial headquarters is in Tokyo, its product development is in Taiwan, and sales is in the U.S.A.This is an example of an integrated global network of operations called transnationals.Experts call this the fourth stage of globalization.In the first stage, companies operate in one country and sell into others.In the second-stage, multinationals set up foreign subsidiaries to handle one country’s sales.The third stage involves operating an entire line of business in another country.While running a fourth stage company – the transnational – is challenging, it appears to be perfectly suited to today’s globalized world.

Answers to Discussion Questions

  1. Explain the effects of technology on globalization.

Technology has had a profound effect on globalization.Advances in technology, particularly the Internet, has allowed the dispersal of key corporate functions.It has allowed a company like Trend Micro to have its financial headquarters in Tokyo, product development in Taiwan, and sales in the U.S.A. and yet seamlessly operate these far-flung offices as one unit.It has quickened communication and allowed companies to use quick response as a competitive weapon.

  1. What are the effects of globalization on firms like Trend Micro and Wipro?

Globalization has allowed firms like Trend Micro and Wipro to fully exploit national differences in factor endowments.Trend Micro can make use of the comparative advantage of many countries to set up specific operations in each country.Wipro can make use of labor cost advantage by employing software engineers in India to serve the global market. Thus, the company has 17,000 (out of a total of 20,000) Indian software engineers who perform high quality jobs at less than one-fifth of U.S. labor costs.

  1. In your opinion, why has globalization occurred?What are your concerns regarding globalization?

There are many trends driving globalization.Increased communication and travel among people of various countries as well as a trend toward convergence in tastes and preferences (more pronounced in some product areas than others) have propelled the world toward globalization.However, technology, particularly the Internet, is the key driver.Coordinating far-flung activities is enabled by Internet technologies.This means that a firm can look for factor advantages anywhere in the world.

Globalization does come with some concerns.It is likely to further drive a wedge between the “haves” and the “have not’s” of the world. Globalization can increase the wages in certain countries in certain employment categories and make it harder for the poor to afford basic amenities.

A New Global Economy

During the past 15 years, many of the world’s nations have increasingly tried to erase barriers to free trade that had been erected over time.The two major developments favoring free trade are:

  • The emergence of the World Trade Organization (WTO), and
  • The emergence of regional trade blocs, such as the North American Free Trade Agreement (NAFTA), the expanded EU, and other regional trade agreements like MERCOSUR in South America.

The General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO)

GATT was created after the Second World War for the principal purpose of reducing tariffs and removing non-tariff barriers to international trade. However, countries continued to impose various non-tariff barriers against foreign competitors.

The World Trade Organization

The Uruguay Round of GATT created the World Trade Organization (WTO) to enforce the GATT agreement.GATT was always considered as a halfway agreement among member nations that allowed them to effectively ignore any GATT rulings they did not like.The WTO, by contrast, is an institution, not an agreement, which will have the authority to set and enforce rules governing trade between more than 153 member countries.

Settlement of Disputes by the WTO

The WTO dispute settlement procedurecalls for the establishment of a panel of trade experts to resolve disputes. If the two countries involved in the dispute are unable to agree on the members of the panel, the WTO director general selects the panel. The WTO must rule on member complaints within one year, Decisions by the trade panel are binding unless overturned by consensus of the WTO membership. The country that is found guilty of violating fair-trade rules has two choices: (1) change its law or (2) face sanctions, most likely in the form of tariffs slapped on its exports by the complaining country. The WTO does not have the legal power to change U.S. laws.
Country-Level Economic Integration

Continental trade blocs are emerging in many parts of the world almost in tandem.There are three important features of the current wave of regionalism.First, almost every country belongs to at least one trade bloc.Second, most trade blocs have been formed among neighboring countries, many along continental lines.Third, regional arrangements are put forward or accelerated in various parts of the world. Figure 2-1 illustrates the various levels at which the countries may economically integrate.There are five major types of trade blocs:

  • Free Trade Area (FTA)
  • Customs union
  • Common market
  • Economic union
  • Political union

The essential features of each type of trade bloc are illustrated in Table 2-1.

The Effects of Economic Integration

There are two main categories of effects resulting from economic integration: static and dynamic.A common market is the most advanced form of economic integration among countries.

Static Effects of Economic Integration

Common external trade barriers and free trade among member countries have both positive and negative effects on trade patterns.The positive trade effect occurs when free trade among member countries leads to the substitution of inefficient domestic production in a common market country for efficient production in another country also in the common market.When such new trade is created among member countries that does not displace third-country imports, it is called trade creation.However, lowering intra-regional barriers leaves relatively high barriers to non-members.If this leads to a substitution of efficient third-country production by inefficient production in a common market country, it may result in trade diversion.

Dynamic Effects of Economic Integration

Market extension is one benefit of economic integration.Producers have free access to the national markets of all member countries, unhindered by import restrictions.It promotes economies of scale, improves productivity, intensifies competition, and results in increases in firm size.

Supply-Side Economics Effects

Figure 2-2 illustrates various benefits of regional economic integration.Regional economic agreements thus are supply-side-led initiatives. The producers are given the initial cost break, which is passed on to primary consumers and eventually trickles down to the entire economy.

Major Regional Economic Agreement Initiatives

The two most prominent regional trade blocs formed to promote regional economic integration are the North American Free Trade Agreement and the European Union.

The North American Free Trade Agreement

The North American Free Trade Agreement (NAFTA) is a free trade agreement that went into effect on January 1, 1994.NAFTA links the United States, Canada, and Mexico in a free trade area of 450 million customersand over $15.4 trillion of annual output.Figure 2.3 is a map of NAFTA.Notwithstanding the long term benefits of NAFTA to all three member countries, there has been some grumbling from those industries that are affected by NAFTA’s free trade initiatives.Practical Insight 2.1 illustrates one such complaint lodged by Mexican farmers.

The U.S. is committed to expand NAFTA to include all countries in the Western Hemisphere to form the Free Trade Area of the Americas (FTAA).

Association of Southeast Asian Nations

The Association of Southeast Asian Nations or ASEAN was established on August 8, 1967 in Bangkok by Indonesia, Malaysia, Philippines, Singapore, and Thailand.They were later joined by Brunei Darussalam, Vietnam, Lao PDR, Myanmar, and Cambodia.The ASEAN region has a population of about 565 million, a total area of 4.6 million square kilometers, a combined GDP of almost U.S. $ 1,100 billion, and a total trade of U.S. $ 1,400 billion. Figure 2.4 is a map of ASEAN.

MERCOSUR

The MERCOSUR (Mercado Comun del Sur, the Common Market of the South) comprises Argentina, Brazil, Paraguay, and Uruguay.It is a market area of nearly 266.6 million people, an area of about 4.9 million square miles and a combined gross regional product in excess of $1.1 trillion, and $2.8 trillion in purchasing power parity. It is also Latin America’s largest industrial base.Figure 2.5 is a map of MERCOSUR.

The European Union

The European Union (EU), historically known as the Common Market, was created after World War II to unite the nations of Europe through peaceful means and to create conditions for the economic recovery and growth of Europe after the devastation of the War.Figure 2.6 is a map of the EU.Twenty-seven countries are now members of the EU.

Will Regional Trade Blocs Promote Global Free Trade?

It has been estimated that trade among members of regional trade agreements show dramatic increases from 1990 to 2006. A significant phenomenon that was partly an outcome of the drive towards free trade is what is commonly known as globalization.It is a process that has resulted in increasing interconnectedness and interdependence among the nations of the world.

Globalization

Globalization is a phenomenon that has remade the economy of virtually every nation, reshaped almost every industry and touched billions of lives, often in surprising and ambiguous ways.Globalization is the growing economic interdependence of countries worldwide, the increasing integration of economic life across political boundaries, through the increasing volume and variety of cross-border transactions in goods, services, capital flows, and rapid and widespread diffusion of technology.

Specific Drivers of Globalization

  • Tremendous growth in international trade and commerce
  • Innovations in information technology and transportation
  • Porous borders between countries
  • The globalization of financial markets
  • The creation of a global labor force (Practical Insight 2.2)
  • Rapidly falling freight costs

The Two Sides of Globalization

The growth of globalization has triggered a heated debate between constituencies supporting this phenomenon and those dramatically opposing it. The key arguments favoring globalization are summarized below:

  • International economic integration is not only good for the poor, it is essential.
  • Globalization has improved the lot of hundreds of millions of poor people around the world.
  • Globalization will allow low-income countries to sell more exports, increase the wages of workers, entice new foreign capital and become successful participants in the global market place.
  • Contrary to what critics believe, corporations do not find the cheapest place to do business; rather they shift production to those countries wherein labor is most productive, not cheap.
  • Technology has been the main driver of globalization.Technological advances offer an enormous, indeed unprecedented, scope for raising living standards in the third world.

Arguments against globalization are as follows:

  • Globalization and deregulation of the economy do not work if the institutions required to make them work are absent (e.g., Russia).
  • The gap between the rich and the poor has been growing, and even the number in absolute poverty has increased.

Country-Specific Economic Environments and Country Competitiveness

The macroeconomic environment is the global canopy under which international business is conducted. The international firm must understand the economic environments, infrastructure development relative to other nations, and effects of membership in a regional economic integration agreement for various countries. This understanding will subsequently lead to a deeper understanding of relative country competitiveness.

DISCUSSION QUESTIONS

  1. Will NAFTA evolve into an economic union like the European Union in the future?

NAFTA is a free trade agreement.As pointed out in the chapter, a free trade area is the loosest form of economic integration.In a free trade area, bloc member countries eliminate trade barriers among member countries, but retain the right to impose their own separate trade barriers on trade with countries outside of the trade bloc.The EU is an economic union, on the other hand.An economic union is a common market wherein the national economic policies of member countries are also harmonized.An economic union demands the transfer of considerable economic sovereignty to supranational institutions.

Opinions are likely to differ on whether the NAFTA will evolve into an economic union.The chief barrier could be political.Would the U.S., Canada, and Mexico be willing to transfer economic sovereignty to a supranational institution?Also, would they agree on a common currency, similar to the Euro?This question is likely to stir a debate in the classroom.

  1. Are you in favor of free trade, even if it causes unemployment in some domestic industries?

Student opinions could vary on this issue.Taking the NAFTA as an example, it is possible that there are students who have lost jobs due to free trade or have seen family members lose jobs due to free trade.They are likely to oppose it.It is important to point out the economic benefits of free trade, particularly trade creation and market extension. The other point is this:if free trade agreements are entered into by other countries, then the ones who are not part of such an agreement may be at a disadvantage.

  1. Does the WTO impinge upon the sovereignty of nation states?

The Uruguay Round of GATT created the World Trade Organization (WTO) to enforce the GATT agreement.In 1995 the WTO replaced the GATT.The WTO is an institution which will have the authority to set and enforce rules governing trade between more than 153 member countries. Fears have been expressed that the WTO could become a foreign-dominated Supreme Court that would result in a loss of national sovereignty of member countries.This is, however, wrong.The WTO cannot change the laws in any country.It allows a country that has won a ruling to enact retaliatory measures against the country that lost the ruling.The WTO does not interfere in the affairs of any member country.

  1. Is globalization inevitable in the world of today?Can the drivers of globalization be controlled by nation states?

The key driver of globalization is technology, particularly Internet technology.The rate of Internet adoption suggests that this force is going to gather more steam and is not likely to be abated.This means that globalization is inevitable in the world of today.Measures are being enacted to break down trade barriers, once again favoring globalization.

It is unlikely that the drivers of globalization can be controlled by nation states.As pointed out in the chapter, almost every country belongs to a regional economic bloc.To a large extent, their policies need to support economic integration, not isolation. Countries that do not yet belong to a regional economic bloc, such as China and India, can enact measures to thwart globalization.However, this is likely to be short-lived as these are two countries that have benefited tremendously from globalization.