The Great Convergence by Richard Baldwin
Whenever absolute or relative prices of goods or services are different in different places, an arbitrage opportunity exists for business. Many such opportunities go unfulfilled because it is ultimately not profitable to pursue them. Businesses will readily expand and globalize if given the opportunity, but practical constraints usually get in the way. The three main constraints that prevent globalization are a high cost of moving goods, a high cost of moving ideas, and a high cost of moving people. Throughout history, these constraints have been softened one at a time in a specific order. There have been multiple waves of globalization, each with a distinct character.
The Pre-Globalized World
In the agrarian pre-industrial world, each of the three main constraining costs (cost of moving goods, cost of moving ideas, cost of moving people) was very high and there was little distinction between the three. The world economy was not an interconnected network but rather a patchwork of largely self-sufficient village-sized economies. Virtually nothing was consumed very far from where it was produced. The best means of transportation were animal-powered caravans on land and sailboats at sea, with all options being slow, expensive, risky, and low in capacity. The major Eurasian civilizations were aware of one another and engaged in some international trade, but it was largely limited to luxuries, rarities, and curiosities. The average person’s lifestyle was not affected by long-distance trade in any way. Most people lived in agrarian poverty and the economy was stagnant.
The Great Divergence
Globalization’s first breakthrough began around 1820 with the rise of steam power. Railroads and steam-powered ships could cheaply transport materials and finished goods at a massive scale across continental distances. The first of the three constraints was lifted: the cost of moving goods was no longer a major hindrance for business, but the cost of moving ideas and the cost of moving people remained high.
It was no longer strictly necessary for physical goods to be produced near where they were consumed. Specialized businesses could now produce goods at a massive scale from a central hub and then sell them to a widely dispersed customer market.
North America and Europe (the “Global North”) became the first places in the world to use these new industrial-era technologies. The Global North became increasingly urbanized and its economy became increasingly defined by manufacturing rather than agriculture. Rather than each country and region being self-sufficient, countries began specializing according to their comparative advantages. Northern countries doubled down on their most productive sectors to create surpluses for export while also replacing their least competitive sectors with imports.
The non-Western world (the “Global South”) did not immediately reap the benefits of this revolution. Since the cost of moving ideas and people remained high, the critical know-how necessary for industrialization remained concentrated in Northern cities and did not spread far. The handicraft-based manufacturing sectors of the ancient Southern civilizations became uncompetitive in the face of industrially-derived alternatives from the North. While the North industrialized, the South deindustrialized; the South’s economy became more dependent on exports of raw materials to the North.
While the Global North experienced unprecedented growth in incomes and standards of living, the Global South remained stagnant and agrarian. The first wave of globalization produced the greatest global inequality in history; at one point, the G7 nations produced as much as two-thirds of the world’s GDP.
The Great Convergence
A second wave of globalization took off around 1990, spurred by major breakthroughs in information and communication technology (ICT). Information could now be managed at a great scale over great distances with negligible cost. The second of the three constraints was lifted: moving goods and ideas became cheap while moving people remained expensive.
ICT enabled new ways of coordinating business activity. Stages of production that once had to be coupled together because of coordination-related constraints could now become uncoupled. In a new wave of specialization, countries and companies could now specialize in individual production stages rather than in complete products. It was now possible to coordinate complicated supply chains at a global scale; finished products could now implicitly contain the labor and expertise of many intermediate firms located in many countries.
International trade deals started going beyond just tariffs and expanded to cover topics like competition law, intellectual property protections, capital controls, investor dispute resolution, and business visas. Companies could now outsource their uncompetitive in-house production stages to other firms in other countries, all while remaining assured that their specifications and quality standards would still be met. Global businesses now had access both to high technology and to cheap labor; previously they could only have one or the other.
Northern companies offshored many low-skill and labor-intensive jobs to Southern countries, arbitraging the enormous wage gaps left behind from the first wave of globalization. Unlike in the first wave, Northern businesses brought their know-how and expertise with them to the South. Expertise was now contained within individual global supply networks rather than at a geographic level.
The Global North deindustrialized, transitioning from a factory economy to a headquarters economy. Northern firms that engaged in offshoring rapidly became much more competitive, leading to lower prices for consumers and very high returns for investors. Manufacturing increasingly became viewed as a commodified business; companies differentiated themselves with their pre-production and post-production rather than their fabrication. The Northern economies became increasingly service-based and office-based, adding lots of new high-quality white-collar jobs requiring high levels of skill. Thanks largely to computers, white-collar jobs became increasingly broad in scope and workers started having ever-larger professional networks. The manufacturing sector in the North got hollowed out; the manufacturing jobs that remained in the North tended to require higher levels of skill. The loss of low-skill manufacturing, the widening gap between skilled and unskilled workers, and the outsized returns on capital all served to increase perceived inequality and polarization within Northern countries. Governments became more skeptical of programs where the costs were nationalized but the benefits were global (eg funding for basic research) and gravitated towards programs that were more guaranteed to have local returns (eg worker upskilling).
For the Global South, offshoring presented an enormous development opportunity. Rather than make entire supply chains from scratch as the North had once done, the South only needed to insert itself into pre-existing supply chains. Many Southern countries unilaterally slashed tariffs and enacted pro-business policy reforms to make themselves more attractive to Northern firms. The technical expertise that Northern firms implicitly brought with them as part of offshoring created spillover effects in Southern economies. The South industrialized and urbanized at a much more rapid rate than the North had ever done. The South grew much faster than the North, reducing inequality at the global level and partially reversing the effects of the previous wave. Due to the overall rise in global manufacturing, the second wave spurred a major boom in demand for commodities, creating an economic opening for resource-rich exporter countries. Due to the self-reinforcing power of network effects and economies of scale, the South’s economic gains were highly concentrated in a few cities and in a few countries. Most of the global manufacturing share given up by the North went to just six countries: China, India, Indonesia, Thailand, South Korea, and Poland.
Since the cost of moving people remained high (plane-powered business travel remained slow and expensive), the ICT revolution produced some counterintuitive outcomes. In spite of ICT seemingly making distance irrelevant, urbanization continued to intensify even in already-urbanized rich countries; the North’s new innovation-centric and office-centric economies required lots of experts to be in close proximity. ICT did not make business travel irrelevant but rather caused it to increase. Northern countries overwhelmingly preferred offshoring to countries in a similar time zone and a short travel distance, even if it meant paying higher wages (eg US to Mexico, Germany to Poland, Japan to Southeast Asia).
A Possible Future
The need for interpersonal networks, physical proximity, and face-to-face interactions is the last remaining constraint on globalization. The first wave of globalization uncoupled production from consumption and the second wave uncoupled the various stages of production; the next wave will seek to uncouple labor services from laborers themselves.
Business travel and immigration are unlikely to ever become rapid and seamless. Rather than trying to tame distance, a more likely outcome is that technology will try to make the location of workers irrelevant. Virtual meeting technology will try to replicate as much of the in-person meeting experience as possible. Improving telerobotics will allow workers to operate machinery that is very far away, effectively allowing them to virtually commute to other countries. Improved real-time translation may help make language barriers irrelevant.
The third wave of globalization will allow for an even finer degree of specialization and fragmentation of production. The third wave will probably act similarly on the service sector as the second wave did on the manufacturing sector. Low-skill Northern service jobs previously protected by the high cost of moving people may find themselves more easily offshored, further increasing the pressure on Northern workers to be highly skilled. Remote regions of the world that were bypassed by the second wave because of their lack of proximity to established markets (eg sub-Saharan Africa, South America) will be given a new opportunity to join the global economy. Compared to the first wave, the second wave of industrialization was faster, more unpredictable, and more difficult for governments to control; the third wave is likely to be even more so.