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What Is Economic Integration?

Economic integration explained, real-world example of economic integration, the bottom line.

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Economic Integration Definition and Real World Example

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Economic integration is an arrangement among nations that typically includes the reduction or elimination of trade barriers and the coordination of monetary and fiscal policies . Economic integration aims to reduce costs for both consumers and producers and to increase trade between the countries involved in the agreement.

Economic integration is sometimes referred to as regional integration, as it often occurs among neighboring nations.

Key Takeaways

• Economic integration, or regional integration, is an agreement among nations to reduce or eliminate trade barriers and to coordinate monetary and fiscal policies.
• The European Union, for example, represents an economic integration among 27 countries.
• Strict nationalists may oppose economic integration due to concerns over a loss of sovereignty.

When regional economies agree on integration, trade barriers fall and economic and political coordination increases. 

Specialists in this area define seven stages of economic integration: a preferential trading area, a free trade area, a customs union, a common market, an economic union, an economic and monetary union, and complete economic integration. The final stage represents a total harmonization of fiscal policy and a complete monetary union.

Advantages of Economic Integration

The advantages of economic integration fall into three categories: trade creation, employment opportunities, and consensus and cooperation.

More specifically, economic integration typically leads to a reduction in the cost of trade, improved availability of goods and services, a wider selection of them, and gains in efficiency that lead to greater purchasing power.

Economic integration can reduce the costs of trade, improve the availability of goods and services, and increase consumer purchasing power in member nations.

Employment opportunities tend to improve because  trade liberalization leads to market expansion, technology sharing, and cross-border investment.

Political cooperation among countries also can improve because of stronger economic ties, which provide an incentive to resolve conflicts peacefully and lead to greater stability.

The Costs of Economic Integration

Despite the benefits, economic integration has costs. These fall into three categories:

• Diversion of trade: Trade can be diverted from non-members to members, even if it is economically detrimental for the member state.
• Erosion of national sovereignty: Members of economic unions typically are required to adhere to rules on trade, monetary policy , and fiscal policies established by an unelected external policymaking body.
• Employment shifts and reductions: Economic integration can cause companies to move their production operations to areas within the economic union that have cheaper labor prices. Conversely, employees may move to areas with better wages and employment opportunities.

Because economists and policymakers believe economic integration leads to significant benefits, many institutions attempt to measure the degree of economic integration across countries and regions. The methodology for measuring economic integration typically involves multiple economic indicators including trade in goods and services, cross-border capital flows, labor migration, and others. Assessing economic integration also includes measures of institutional conformity, such as membership in trade unions and the strength of institutions that protect consumer and investor rights.

The European Union (EU) was created in 1993 and included 27 member states in 2024. Since 1999, 20 of those nations have adopted the euro as a shared currency. According to data from the World Bank, the EU accounted for roughly 16.6% of the world's gross domestic product in 2022.

The United Kingdom voted in 2016 to leave the EU. In January 2020, British lawmakers and the European Parliament voted to accept the United Kingdom's withdrawal. The UK officially split from the EU on January 1, 2021.

What Are Examples of Economic Integration?

There are numerous examples of economic integration around the world. In North America, the United States–Mexico–Canada Agreement ( USCMA ) is an example of a free trade agreement between the three countries. The Asia-Pacific Economic Cooperation is a forum of 21 Pacific Rim countries aimed at fostering free trade across the region. As mentioned above, the EU is another such example of economic integration, as is the Eurasian Economic Union (EAEU).

What Are Risks of Economic Integration?

Economic integration can come with downsides and risks. Primarily, countries participating in regional integration may have divergent priorities when it comes to fiscal and monetary policy. Resolving such conflicts can be challenging and costly in terms of time and resources. In addition, economic integration can create a system in which a select group of stakeholders reap the economic benefits, such as more revenue from trade, while others bear the costs, such as job market shifts. These are important considerations to weigh when assessing the value of economic integration.

What Are Benefits of Economic Integration?

Economic integration can increase trade, benefiting both producers, consumers, and involved countries. For instance, with the elimination of trade barriers, a firm may be able to produce and sell more products, earning more revenue, and increasing their home country's gross domestic product (GDP) . For customers in other countries, they can count on having more product selection and potentially lower costs, as well.

Economic integration is a form of coordination between different states, in which barriers to trade are eliminated and fiscal and monetary policies are harmonized. These arrangements can lead to increased economic activity, job creation, and stronger political ties. They may also come with drawbacks, such as trade diversion and loss of national sovereignty.

The EU is a well-known example of regional economic integration, as it is comprised of 27 member states, 20 of which use the same currency.

Pressbooks. " Core Principles of International Marketing: 2.4 Regional Economic Integration ."

Allianz Global Investors. " Allianz Global Investors Insights. "

European Commission. " Official EU Currency. "

The World Bank Group. " GDP (Current US$) - European Union, World ."

Library of Congress. " BREXIT: Sources of Information ."

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August 25, 2006

Global Economic Integration: What's New and What's Not?

Chairman Ben S. Bernanke

At the Federal Reserve Bank of Kansas City's Thirtieth Annual Economic Symposium, Jackson Hole, Wyoming

When geographers study the earth and its features, distance is one of the basic measures they use to describe the patterns they observe. Distance is an elastic concept, however. The physical distance along a great circle from Wausau, Wisconsin to Wuhan, China is fixed at 7,020 miles. But to an economist, the distance from Wausau to Wuhan can also be expressed in other metrics, such as the cost of shipping goods between the two cities, the time it takes for a message to travel those 7,020 miles, and the cost of sending and receiving the message. Economically relevant distances between Wausau and Wuhan may also depend on what trade economists refer to as the "width of the border," which reflects the extra costs of economic exchange imposed by factors such as tariff and nontariff barriers, as well as costs arising from differences in language, culture, legal traditions, and political systems.

One of the defining characteristics of the world in which we now live is that, by most economically relevant measures, distances are shrinking rapidly. The shrinking globe has been a major source of the powerful wave of worldwide economic integration and increased economic interdependence that we are currently experiencing. The causes and implications of declining economic distances and increased economic integration are, of course, the subject of this conference.

The pace of global economic change in recent decades has been breathtaking indeed, and the full implications of these developments for all aspects of our lives will not be known for many years. History may provide some guidance, however. The process of global economic integration has been going on for thousands of years, and the sources and consequences of this integration have often borne at least a qualitative resemblance to those associated with the current episode. In my remarks today I will briefly review some past episodes of global economic integration, identify some common themes, and then put forward some ways in which I see the current episode as similar to and different from the past. In doing so, I hope to provide some background and context for the important discussions that we will be having over the next few days.

A Short History of Global Economic Integration As I just noted, the economic integration of widely separated regions is hardly a new phenomenon. Two thousand years ago, the Romans unified their far-flung empire through an extensive transportation network and a common language, legal system, and currency. One historian recently observed that "a citizen of the empire traveling from Britain to the Euphrates in the mid-second century CE would have found in virtually every town along the journey foods, goods, landscapes, buildings, institutions, laws, entertainment, and sacred elements not dissimilar to those in his own community." (Hitchner, 2003, p. 398). This unification promoted trade and economic development.

A millennium and a half later, at the end of the fifteenth century, the voyages of Columbus, Vasco da Gama, and other explorers initiated a period of trade over even vaster distances. These voyages of discovery were made possible by advances in European ship technology and navigation, including improvements in the compass, in the rudder, and in sail design. The sea lanes opened by these voyages facilitated a thriving intercontinental trade--although the high costs of and the risks associated with long voyages tended to limit trade to a relatively small set of commodities of high value relative to their weight and bulk, such as sugar, tobacco, spices, tea, silk, and precious metals. Much of this trade ultimately came under the control of the trading companies created by the English and the Dutch. These state-sanctioned monopolies enjoyed--and aggressively protected--high markups and profits. Influenced by the prevailing mercantilist view of trade as a zero-sum game, European nation-states competed to dominate lucrative markets, a competition that sometimes spilled over into military conflict.

"But foreign trade, which brings from Calcutta and India and such places wares like costly silks, articles of gold, and spices--which minister only to ostentation but serve no useful purpose, and which drain away the money of the land and people--would not be permitted if we had proper government and princes... God has cast us Germans off to such an extent that we have to fling our gold and silver into foreign lands and make the whole world rich, while we ourselves remain beggars." (James, 2001, p. 8)

The structure of trade during the post-Napoleonic period followed a "core-periphery" pattern. Capital-rich Western European countries, particularly Britain, were the center, or core, of the trading system and the international monetary system. Countries in which natural resources and land were relatively abundant formed the periphery. Manufactured goods, financial capital, and labor tended to flow from the core to the periphery, with natural resources and agricultural products flowing from the periphery to the core. The composition of the core and the periphery remained fairly stable, with one important exception being the United States, which, over the course of the nineteenth century, made the transition from the periphery to the core. The share of manufactured goods in U.S. exports rose from less than 30 percent in 1840 to 60 percent in 1913, and the United States became a net exporter of financial capital beginning in the late 1890s. 1

For the most part, government policies during this era fostered openness to trade, capital mobility, and migration. Britain unilaterally repealed its tariffs on grains (the so-called corn laws) in 1846, and a series of bilateral treaties subsequently dismantled many barriers to trade in Europe. A growing appreciation for the principle of comparative advantage, as forcefully articulated by Adam Smith and David Ricardo, may have made governments more receptive to the view that international trade is not a zero-sum game but can be beneficial to all participants.

That said, domestic opposition to free trade eventually intensified, as cheap grain from the periphery put downward pressure on the incomes of landowners in the core. Beginning in the late 1870s, many European countries raised tariffs, with Britain being a prominent exception. Britain did respond to protectionist pressures by passing legislation that required that goods be stamped with their country of origin. This step provided additional grist for trade protesters, however, as the author of one British anti-free-trade pamphlet in the 1890s lamented that even the pencil he used to write his protest was marked "made in Germany" (James, 2001, p. 15). In the United States, tariffs on manufactures were raised in the 1860s to relatively high levels, where they remained until well into the twentieth century. Despite these increased barriers to the importation of goods, the United States was remarkably open to immigration throughout this period.

Unfortunately, the international economic integration achieved during the nineteenth century was largely unraveled in the twentieth by two world wars and the Great Depression. After World War II, the major powers undertook the difficult tasks of rebuilding both the physical infrastructure and the international trade and monetary systems. The industrial core--now including an emergent Japan as well as the United States and Western Europe--ultimately succeeded in restoring a substantial degree of economic integration, though decades passed before trade as a share of global output reached pre-World War I levels.

One manifestation of this re-integration was the rise of so-called intra-industry trade. Researchers in the late-1960s and the 1970s noted that an increasing share of global trade was taking place between countries with similar resource endowments, trading similar types of goods--mainly manufactured products traded among industrial countries. 2 Unlike international trade in the nineteenth century, these flows could not be readily explained by the perspectives of Ricardo or of the Swedish economists Eli Heckscher and Bertil Ohlin that emphasized national differences in endowments of natural resources or factors of production. In influential work, Paul Krugman and others have since argued that intra-industry trade can be attributed to firms' efforts to exploit economies of scale, coupled with a taste for variety by purchasers.

Postwar economic re-integration was supported by several factors, both technological and political. Technological advances further reduced the costs of transportation and communication, as the air freight fleet was converted from propeller to jet and intermodal shipping techniques (including containerization) became common. Telephone communication expanded, and digital electronic computing came into use. Taken together, these advances allowed an ever-broadening set of products to be traded internationally. In the policy sphere, tariff barriers--which had been dramatically increased during the Great Depression--were lowered, with many of these reductions negotiated within the multilateral framework provided by the General Agreement on Tariffs and Trade. Globalization was, to some extent, also supported by geopolitical considerations, as economic integration among the Western market economies became viewed as part of the strategy for waging the Cold War. However, although trade expanded significantly in the early post-World War II period, many countries--recalling the exchange-rate and financial crises of the 1930s--adopted regulations aimed at limiting the mobility of financial capital across national borders.

Several conclusions emerge from this brief historical review. Perhaps the clearest conclusion is that new technologies that reduce the costs of transportation and communication have been a major factor supporting global economic integration. Of course, technological advance is itself affected by the economic incentives for inventive activity; these incentives increase with the size of the market, creating something of a virtuous circle. For example, in the nineteenth century, the high potential return to improving communications between Europe and the United States prompted intensive work to better understand electricity and to improve telegraph technology--efforts that together helped make the trans-Atlantic cable possible.

A second conclusion from history is that national policy choices may be critical determinants of the extent of international economic integration. Britain's embrace of free trade and free capital flows helped to catalyze international integration in the nineteenth century. Fifteenth-century China provides an opposing example. In the early decades of that century, the Chinese sailed great fleets to the ports of Asia and East Africa, including ships much larger than those that the Europeans were to use later in the voyages of discovery. These expeditions apparently had only limited economic impact, however. Ultimately, internal political struggles led to a curtailment of further Chinese exploration (Findlay, 1992). Evidently, in this case, different choices by political leaders might have led to very different historical outcomes.

A third observation is that social dislocation, and consequently often social resistance, may result when economies become more open. An important source of dislocation is that--as the principle of comparative advantage suggests--the expansion of trade opportunities tends to change the mix of goods that each country produces and the relative returns to capital and labor. The resulting shifts in the structure of production impose costs on workers and business owners in some industries and thus create a constituency that opposes the process of economic integration. More broadly, increased economic interdependence may also engender opposition by stimulating social or cultural change, or by being perceived as benefiting some groups much more than others.

The Current Episode of Global Economic Integration How does the current wave of global economic integration compare with previous episodes? In a number of ways, the remarkable economic changes that we observe today are being driven by the same basic forces and are having similar effects as in the past. Perhaps most important, technological advances continue to play an important role in facilitating global integration. For example, dramatic improvements in supply-chain management, made possible by advances in communication and computer technologies, have significantly reduced the costs of coordinating production among globally distributed suppliers.

Another common feature of the contemporary economic landscape and the experience of the past is the continued broadening of the range of products that are viewed as tradable. In part, this broadening simply reflects the wider range of goods available today--high-tech consumer goods, for example--as well as ongoing declines in transportation costs. Particularly striking, however, is the extent to which information and communication technologies now facilitate active international trade in a wide range of services, from call center operations to sophisticated financial, legal, medical, and engineering services.

The critical role of government policy in supporting, or at least permitting, global economic integration, is a third similarity between the past and the present. Progress in trade liberalization has continued in recent decades--though not always at a steady pace, as the recent Doha Round negotiations demonstrate. Moreover, the institutional framework supporting global trade, most importantly the World Trade Organization, has expanded and strengthened over time. Regional frameworks and agreements, such as the North American Free Trade Agreement and the European Union's "single market," have also promoted trade. Government restrictions on international capital flows have generally declined, and the "soft infrastructure" supporting those flows--for example, legal frameworks and accounting rules--have improved, in part through international cooperation.

In yet another parallel with the past, however, social and political opposition to rapid economic integration has also emerged. As in the past, much of this opposition is driven by the distributional impact of changes in the pattern of production, but other concerns have been expressed as well--for example, about the effects of global economic integration on the environment or on the poorest countries.

What, then, is new about the current episode? Each observer will have his or her own perspective, but, to me, four differences between the current wave of global economic integration and past episodes seem most important. First, the scale and pace of the current episode is unprecedented. For example, in recent years, global merchandise exports have been above 20 percent of world gross domestic product, compared with about 8 percent in 1913 and less than 15 percent as recently as 1990; and international financial flows have expanded even more quickly. 3 But these data understate the magnitude of the change that we are now experiencing. The emergence of China, India, and the former communist-bloc countries implies that the greater part of the earth's population is now engaged, at least potentially, in the global economy. There are no historical antecedents for this development. Columbus's voyage to the New World ultimately led to enormous economic change, of course, but the full integration of the New and the Old Worlds took centuries. In contrast, the economic opening of China, which began in earnest less than three decades ago, is proceeding rapidly and, if anything, seems to be accelerating.

Second, the traditional distinction between the core and the periphery is becoming increasingly less relevant, as the mature industrial economies and the emerging-market economies become more integrated and interdependent. Notably, the nineteenth-century pattern, in which the core exported manufactures to the periphery in exchange for commodities, no longer holds, as an increasing share of world manufacturing capacity is now found in emerging markets. An even more striking aspect of the breakdown of the core-periphery paradigm is the direction of capital flows: In the nineteenth century, the country at the center of the world's economy, Great Britain, ran current account surpluses and exported financial capital to the periphery. Today, the world's largest economy, that of the United States, runs a current-account deficit, financed to a substantial extent by capital exports from emerging-market nations.

Third, production processes are becoming geographically fragmented to an unprecedented degree. 4 Rather than producing goods in a single process in a single location, firms are increasingly breaking the production process into discrete steps and performing each step in whatever location allows them to minimize costs. For example, the U.S. chip producer AMD locates most of its research and development in California; produces in Texas, Germany, and Japan; does final processing and testing in Thailand, Singapore, Malaysia, and China; and then sells to markets around the globe. To be sure, international production chains are not entirely new: In 1911, Henry Ford opened his company's first overseas factory in Manchester, England, to be closer to a growing source of demand. The factory produced bodies for the Model A automobile, but imported the chassis and mechanical parts from the United States for assembly in Manchester. Although examples like this one illustrate the historical continuity of the process of economic integration, today the geographical extension of production processes is far more advanced and pervasive than ever before. As an aside, some interesting economic questions are raised by the fact that in some cases international production chains are managed almost entirely within a single multinational corporation (roughly 40 percent of U.S. merchandise trade is classified as intra-firm) and in others they are built through arm's-length transactions among unrelated firms. But the empirical evidence in both cases suggests that substantial productivity gains can often be achieved through the development of global supply chains. 5

The final item on my list of what is new about the current episode is that international capital markets have become substantially more mature. Although the net capital flows of a century ago, measured relative to global output, are comparable to those of the present, gross flows today are much larger. Moreover, capital flows now take many more forms than in the past: In the nineteenth century, international portfolio investments were concentrated in the finance of infrastructure projects (such as the American railroads) and in the purchase of government debt. Today, international investors hold an array of debt instruments, equities, and derivatives, including claims on a broad range of sectors. Flows of foreign direct investment are also much larger relative to output than they were fifty or a hundred years ago. 6 As I noted earlier, the increase in capital flows owes much to capital-market liberalization and factors such as the greater standardization of accounting practices as well as to technological advances.

Conclusion By almost any economically relevant metric, distances have shrunk considerably in recent decades. As a consequence, economically speaking, Wausau and Wuhan are today closer and more interdependent than ever before. Economic and technological changes are likely to shrink effective distances still further in coming years, creating the potential for continued improvements in productivity and living standards and for a reduction in global poverty.

Further progress in global economic integration should not be taken for granted, however. Geopolitical concerns, including international tensions and the risks of terrorism, already constrain the pace of worldwide economic integration and may do so even more in the future. And, as in the past, the social and political opposition to openness can be strong. Although this opposition has many sources, I have suggested that much of it arises because changes in the patterns of production are likely to threaten the livelihoods of some workers and the profits of some firms, even when these changes lead to greater productivity and output overall. The natural reaction of those so affected is to resist change, for example, by seeking the passage of protectionist measures. The challenge for policymakers is to ensure that the benefits of global economic integration are sufficiently widely shared--for example, by helping displaced workers get the necessary training to take advantage of new opportunities--that a consensus for welfare-enhancing change can be obtained. Building such a consensus may be far from easy, at both the national and the global levels. However, the effort is well worth making, as the potential benefits of increased global economic integration are large indeed.

Bloom, Nick, Raffaella Sadun, and John Van Reenen (2006). "It Ain't What You Do It's the Way That You Do I.T.--Investigating the Productivity Miracle Using the Overseas Activities of U.S. Multinationals," unpublished paper, Centre for Economic Performance, March.

Bordo, Michael, Barry Eichengreen, and Douglas Irwin (1999). "Is Globalization Today Really Different than Globalization a Hundred Years Ago?" NBER Working Paper No. 7195, June.

Corrado, Carol, Paul Lengermann, and Larry Slifman (2005). "The Contribution of MNCs to U.S. Productivity Growth, 1977-2000," unpublished paper, Board of Governors of the Federal Reserve System, July.

Criscuolo, Chiara, and Ralf Martin (2005). "Multinationals and U.S. Productivity Leadership: Evidence from Great Britain," Centre for Economic Performance, Discussion Paper No. 672, January.

Doms, Mark E. and J. Bradford Jensen (1998). "Comparing Wages, Skills, and Productivity between Domestically and Foreign-Owned Manufacturing Establishments in the United States," in R.E. Baldwin, R.E. Lipsey, and J. David Richardson, eds., Geography and Ownership as Bases for Economic Accounting , NBER Studies in Income and Wealth, vol. 59, Chicago, Ill.: University of Chicago Press, pp. 235-58.

Findlay, Ronald (1992). "The Roots of Divergence: Western Economic History in Comparative Perspective," AEA Papers and Proceedings , vol. 82:2, May, pp. 158-61.

Findlay, Ronald, and Kevin O'Rourke (2002). "Commodity Market Integration 1500-2000," Centre for Economic Policy Research, Discussion Paper No. 3125, January.

Grubel, Herbert, and P.J. Lloyd (1975). Intra-Industry Trade , New York, New York: John Wiley & Sons.

Hanson, Gordon, Raymond Mataloni, and Matthew Slaughter (2005). "Vertical Production Networks in Multinational Firms," Review of Economics and Statistics , vol. 87:4, November.

Historical Statistics of the United States: Earliest Times to Present (Millennial Edition) (2006). New York, New York: Cambridge University Press.

Hitchner, Bruce (2003). "Roman Empire," in Joel Mokyr ed., The Oxford Encyclopedia of Economic History , Oxford, England: Oxford University Press, vol. 4, pp. 397-400.

James, Harold (2001) The End of Globalization: Lessons from the Great Depression , Cambridge, Massachusetts: Harvard University Press.

Kurz, Christopher (2006). "Outstanding Outsourcers: A Firm- and Plant-Level Analysis of Production Sharing," Finance and Economics Discussion Series 2006-04, Federal Reserve Board, March.

Maddison, Angus (2001). The World Economy: A Millenial Perspective , Paris, France: OECD Development Centre.

Standage, Tom (1998). The Victorian Internet , New York, New York: Walker Publishing Company.

1.  Data are from Historical Statistics of the United States (2006).  Return to text

2.  See, for example, Grubel and Lloyd (1975).  Return to text

3.  Maddison (2001) and International Monetary Fund data.  Return to text

4.  See, for example, Hanson, Mataloni, and Slaughter (2005).  Return to text

5.  Some of the key empirical papers in this literature are Doms and Jensen (1998); Criscuolo and Martin (2005); Corrado, Lengermann, and Slifman (2005); Bloom, Sadun, and Van Reenen (2006), and Kurz (2006).  Return to text

6.  See, for example, Bordo, Eichengreen, and Irwin (1999).  Return to text

• Economic Integration

Agreements between countries that usually include the elimination of trade barriers and aligning monetary and fiscal policies

What is Economic Integration?

Economic integration involves agreements between countries that usually include the elimination of trade barriers and aligning monetary and fiscal policies, leading to a more inter-connected global economy. Economic integration is consistent with the economic theory, which argues that the global economy is better off when markets can function in unison with minimal government intervention.

Understanding Economic Integration

Economic integration, like the name implies, involves the integration of countries’ economies. Another term to describe it is globalization , which simply refers to the inter-connectedness of businesses and trading among countries. An economy is defined as a set of inter-related activities that determine how limited resources are allocated. In the modern economy, all economies feature a form of a market system. A market-based economy utilizes the economic forces of demand and supply in order to distribute these limited resources.

Traditionally, economies were thought of as separate for each region or country, with each country managing its own separate economy and largely unrelated to other countries. However, globalization allows the movement of goods, services, capital between countries and blurred the distinctions between economies.

Today, there is no economy that functions completely isolated from other economies. There is a simple reason for such an occurrence – trade benefits all economies in most cases. It allows for specializations of economies with comparative advantages and can trade with other economies that possess alternative comparative advantages.

Comparative Advantage Example

For example, consider a country that happens to possess an abundance of oil sands located within its borders. The country can extract the oil and trade it for other resources that it lacks, perhaps food such as corn or wheat.

Another country may enjoy optimal weather for growing such crops and therefore can specialize in growing corn or wheat and trade it for oil to provide energy for their society. It illustrates how trade can benefit all economies by taking advantage of specialization and comparative advantages.

Stages of Economic Integration

Economic integration is expected to improve the outcomes for all economies by many economists and policymakers. Within economics, there are seven stages that lead to complete economic integration:

• Preferential Trading Area
• Free Trade Area
• Customs Union
• Common Market
• Economic Union
• Economic and Monetary Union

Many countries move in and out of the above stages with other partner countries. The best example of complete economic integration is with the European Union (EU) . The EU is made up of separate member countries, including:

There are also many other countries in the EU, totaling 27 separate nations. However, each country functions separately politically and keeps defined borders, different laws, and government systems. Economically, the 27 countries function as one – with free trade between the countries and unified monetary policies and fiscal policies.

Benefits of Economic Integration

Economic integration is beneficial in many ways, as it allows countries to specialize and trade without government interference, which can benefit all economies. It results in a reduction of costs and ultimately an increase in overall wealth.

Trade costs are reduced, and goods and services are more widely available, which leads to a more efficient economy. An efficient economy distributes capital, goods, and services into the areas that demand them the most.

The movement of employees is liberalized under economic integration as well. Normally, employees would need to deal with visas and immigration policies in order to work in another country. However, with economic integration, employees can move freely, and it leads to greater market expansion and technology sharing, which ultimately benefits all economies.

Lastly, political cooperation is encouraged, and there are fewer political conflicts. Political conflicts usually end with economic losses stemming from trade wars or even military wars breaking out, resulting in extreme costs for all combatants.

Drawbacks of Economic Integration

Nationalists, or people who believe that their country is superior to others, are critical of economic integration. In order to appeal to nationalists, some countries employ forms of protectionism, which leads to higher tariffs and less free trade between other countries.

The notable feature of economic integration is the loss of individual central banks who control monetary policy. It leads to less national sovereignty, and the responsibilities of central banks are delegated to an external body instead. The external control becomes troublesome in terms of managing a cohesive fiscal and monetary policy among many different countries.

Related Readings

Thank you for reading CFI’s guide to Economic Integration. To keep advancing your career, the additional CFI resources below will be useful:

• Comparative Advantage
• International Trade
• Market Economy
• Non-Tariff Barriers
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RBA Annual Conference – 2002 Global Economic Integration and Global Inequality David Dollar [1]

Gaps between the poorest and the richest people and countries have continued to widen…This continues the trend of two centuries. Some have predicted convergence, but the past decade has shown increasing concentration of income among people, corporations, and countries . UN Human Development Report 1999

…globalization has dramatically increased inequality between and within nations . Jay Mazur, Foreign Affairs

… inequality is soaring through the globalization period, within countries and across countries. And that's expected to continue . Noam Chomsky

…all the main parties support nonstop expansion in world trade and services although we all know it…makes rich people richer and poor people poorer… Walter Schwarz, The Guardian

The evidence strongly suggests that global income inequality has risen in the last twenty years . Robert Wade

We are convinced that globalization is good and it's good when you do your homework…keep your fundamentals in line on the economy, build up high levels of education, respect rule of law…when you do your part, we are convinced that you get the benefit . President Vicente Fox of Mexico

There is no way you can sustain economic growth without accessing a big and sustained market . President Yoweri Museveni of Uganda

We take the challenge of international competition in a level playing field as an incentive to deepen the reform process for the overall sustained development of the economy. WTO membership works like a wrecking ball, smashing whatever is left in the old edifice of the former planned economy . Jin Liqun, Vice Minister of Finance of China

There is an odd disconnect between debates about globalisation in the North and the South. Among intellectuals in the North one often hears the claim that global economic integration is leading to rising global inequality – that is, that it benefits the rich proportionally more than the poor. In the extreme claims, the poor are actually made out to be worse-off absolutely (as in the quote from Walter Schwarz). In the South, on the other hand, intellectuals and policy-makers often view globalisation as providing good opportunities for their countries and their people. To be sure, they are not happy with the current state of globalisation. President Museveni's quote above, for example, comes in the midst of a speech in the US where he blasts the rich countries for their protectionism against poor countries and lobbies for better market access. But the point of such critiques is that integration – through foreign trade, foreign investment, and immigration – is basically a good thing for poor countries and that the rich countries could do a lot more to facilitate this integration – that is, make it freer. The claims from anti-globalisation intellectuals of the North, on the other hand, lead inescapably to the conclusion that integration is bad for poor countries and that therefore trade and other flows should be more restricted.

The main goal of this essay is to link growing economic integration (‘globalisation’) with trends in growth, poverty, and inequality in the developing world. The phrase ‘global inequality’ is used to mean different things in different discussions – distribution among all the citizens of the world, distribution within countries, distribution among countries, distribution among wage earners – and the paper takes up all the different meanings.

The first half of the essay looks at the link between heightened integration and economic growth of developing countries. The opening-up of big developing countries such as China and India is arguably the most distinctive feature of the wave of globalisation that started around 1980. Individual cases, cross-country statistical analysis, and micro evidence from firms all suggest that this opening-up to trade and direct investment has been a good strategy for such developing countries as China, India, Mexico and Uganda.

How have the economic benefits of globalisation been distributed and what has happened as a result to global poverty and inequality? These are the questions addressed in the second half of this essay. In particular, Section 2 presents evidence in support of five trends in inequality and poverty since 1980:

• Trend #1 – Poor country growth rates have accelerated.
• Trend #2 – The number of poor people in the world has declined significantly, the first such decline in history.
• Trend #3 – Global inequality (among citizens of the world) has declined – modestly – reversing a 200-year-old trend toward higher inequality.
• Trend #4 – There is no general trend toward higher inequality within countries; in particular, among developing countries inequality has decreased in about as many cases as it has increased.
• Trend #5 – Wage inequality is rising worldwide (which may seem to contradict Trend #4, but it does not because wages are a small part of household income in developing countries, which make up the bulk of the world in terms of countries and population).

The conclusions for policy from this review of globalisation and global inequality are very much in the spirit of the comments from Presidents Fox and Museveni. Developing countries have a lot of ‘homework’ to do in order to develop in general and to make effective use of integration as part of their development strategy. Rich countries could do a lot more with foreign aid to help with that homework. And, as Museveni indicates, access to rich country markets is important. There remains a lot of protection in OECD markets against the goods and people of the developing world, and globalisation would do more for developing country growth if developing countries and their people had freer access to those rich country markets.

1. Is there a Link from Integration to Growth?

To keep track of the wide range of explanations that are offered for persistent poverty in developing nations, it helps to keep two extreme views in mind. The first is based on an object gap: Nations are poor because they lack valuable objects like factories, roads, and raw materials. The second view invokes an idea gap: Nations are poor because their citizens do not have access to the ideas that are used in industrial nations to generate economic value…

Each gap imparts a distinctive thrust to the analysis of development policy. The notion of an object gap highlights saving and accumulation. The notion of an idea gap directs attention to the patterns of interaction and communication between a developing country and the rest of the world . (Romer 1993, p 544)

Many developing countries have become more integrated with the global economy in the past two decades, and at the same time their growth rates have accelerated (examples would be Bangladesh, China, India, Mexico, Uganda and Vietnam). A natural question to ask is whether there is a link. In other words, could countries such as Bangladesh, China, India, and Vietnam have grown as rapidly as they have, if they had remained as closed to foreign trade and investment as they were in 1980? This is not the kind of question that can be answered with scientific certainty, but there are several different types of evidence that we can bring to bear on it.

It is useful to begin with what one would expect from economic theory. As suggested by the quote from Paul Romer , traditional growth theory focused on accumulation and the ‘object gap’ between poor countries and rich ones. If the important thing is just to increase the number of factories and workplaces, then it does not matter if this is done in a closed environment or a state-dominated environment. That was the model followed in the extreme by China and the Soviet Union, and to a lesser extent by most developing countries, who followed import-substituting industrialisation strategies throughout the 1960s and 1970s. It was the disappointing results from that approach that led to new thinking both from policy-makers in developing countries as well as from economists studying growth. Romer was one of the pioneers of the new growth theory that put more emphasis on how innovation occurs and is spread and the role of technological advance in improving the standard of living. Different aspects of integration – sending students abroad to study, connecting to the internet, allowing foreign firms to open plants, purchasing the latest equipment and components – can help overcome the ‘idea gap’ that separates poor and rich nations.

What is the evidence on integration spurring growth? There are a large number of case studies that show how this process can work in particular countries. Among the countries that were very poor in 1980, China, India, Vietnam and Uganda provide an interesting range of examples.

China's initial reforms in the late 1970s focused on the agricultural sector and emphasised strengthening property rights, liberalising prices, and creating internal markets. As indicated in Figure 1, liberalising foreign trade and investment were also part of the initial reform program. In the 1980s China removed administrative barriers to trade, before turning to major tariff reductions in the 1990s. The role of international linkages is described in this excerpt from a case study by Richard Eckaus:

After the success of the Communist revolution and the founding of the People's Republic of China, the nation's international economic policies were dominated for at least thirty years by the goal of self-reliance. While this was never interpreted as complete autarky, the aspiration for self-reliance profoundly shaped trade policy, especially with the market economies. China's foreign trade began to expand rapidly as the turmoil created by the Cultural Revolution dissipated and new leaders came to power. Though it was not done without controversy, the argument that opening of the economy to foreign trade was necessary to obtain new capital equipment and new technology was made official policy. The creation of an ‘open door’ policy did not mean the end of foreign trade planning. Although Chinese policy became committed to the expansion of its international trade, the decision-making processes and international trade mechanisms of the pre-reform period continued in full force for several years, to a modified degree for several more years, and still continue to be evident in the licensing controls. At the same time, international transactions outside of the state planning system have been growing. Most obviously, enterprises created by foreign investors have been exempt from the foreign trade planning and control mechanisms. In addition, substantial amounts of other types of trade, particularly the trade of the township and village enterprises and private firms, have been relatively free. The expansion of China's participation in international trade since the beginning of the reform movement in 1978, has been one of the most remarkable features of its remarkable transformation. While GNP was growing at 9 percent from 1978 to 1994, exports grew at about 14 percent and imports at an average of 13 percent per year. The successes contradict several customary generalisations about transition economies and large developing countries – for example, that the transition from central planning to market orientation cannot be made without passing through a difficult period of economic disorganization and, perhaps decline; and that the share of international trade in very large economies cannot grow quickly due to the difficulties of penetrating foreign markets on a larger scale. (Eckaus 1997, p 415)

It is well-known that India pursued an inward-oriented strategy into the 1980s and got disappointing results in terms of growth and poverty reduction. Bhagwati crisply states the main problems and failures of the strategy:

I would divide them into three major groups: extensive bureaucratic controls over production, investment and trade; inward-looking trade and foreign investment policies; and a substantial public sector, going well beyond the conventional confines of public utilities and infrastructure. The former two adversely affected the private sector's efficiency. The last, with the inefficient functioning of public sector enterprises, impaired additionally the public sector enterprises' contribution to the economy. Together, the three sets of policy decisions broadly set strict limits to what India could get out of its investment. (Bhagwati 1992, p 48)

Under this policy regime India's growth in the 1960s (1.4 per cent per annum) and 1970s (−0.3 per cent) was disappointing. During the 1980s India's economic performance improved. However, this surge was fuelled by deficit spending and borrowing from abroad that was unsustainable. In fact, the spending spree led to a fiscal and balance of payments crisis that brought a new, reform government to power in 1991. Srinivasan describes the key reform measures and their results as follows:

In July 1991, the government announced a series of far reaching reforms. These included an initial devaluation of the rupee and subsequent market determination of its exchange rate, abolition of import licensing with the important exceptions that the restrictions on imports of manufactured consumer goods and on foreign trade in agriculture remained in place, convertibility (with some notable exceptions) of the rupee on the current account; reduction in the number of tariff lines as well as tariff rates; reduction in excise duties on a number of commodities; some limited reforms of direct taxes; abolition of industrial licensing except for investment in a few industries for locational reasons or for environmental considerations, relaxation of restrictions on large industrial houses under the Monopolies and Restrictive Trade Practices (MRTP) Act; easing of entry requirements (including equity participation) for direct foreign investment; and allowing private investment in some industries hitherto reserved for public sector investment. (Srinivasan 2001, p 245)

In general, India has gotten good results from its reform program, with per capita income growth above 4 per cent per annum in the 1990s. Growth and poverty reduction have been particularly strong in states that have made the most progress liberalising the regulatory framework and providing a good environment for delivery of infrastructure services (Goswami et al 2002).

The same collection that contains Eckaus's study of China also has a case study of Vietnam:

Vietnam has made a remarkable turnaround during the past decade. In the mid-1980s the country suffered from hyperinflation and economic stagnation; it was not able to feed its population; and hundreds of thousands of people were signaling their dissatisfaction by fleeing in unsafe boats. A decade later, the government had restored macroeconomic stability; growth had accelerated to the 8–9 per cent range; the country had become the second largest rice exporter in the world; and overseas Vietnamese were returning with their capital to take advantage of expanding investment opportunities. During this period there has also been a total transformation of Vietnam's foreign trade and investment, with the economy now far more open than ten years ago. That Vietnam was able to grow throughout its adjustment period can be attributed to the fact that the economy was being increasingly opened to the international market. As part of its overall effort to stabilize the economy, the government unified its various controlled exchange rates in 1989 and devalued the unified rate to the level prevailing in the parallel market. This was tantamount to a 73 per cent real devaluation; combined with relaxed administrative procedures for imports and exports, this sharply increased the profitability of exporting. This…policy produced strong incentives for export throughout most of the 1989–94 period. During these years real export growth averaged more than 25 per cent per annum, and exports were a leading sector spurring the expansion of the economy. Rice exports were a major part of this success in 1989; and in 1993–94 there was a wide range of exports on the rise, including processed primary products (e.g., rubber, cashews, and coffee), labour-intensive manufactures, and tourist services. The current account deficit declined from more than 10 per cent of GDP in 1988 to zero in 1992. Normally, the collapse of financing in this way would require a sharp cutback in imports. However, Vietnam's export growth was sufficient to ensure that imports could grow throughout this adjustment period. It is also remarkable that investment increased sharply between 1988 and 1992, while foreign aid [from the Soviet Union] was drying up. In response to stabilization, strengthened property rights, and greater openness to foreign trade, domestic savings increased by twenty percentage points of GDP, from negative levels in the mid 1980s to 16 per cent of GDP in 1992. (Dollar and Ljunggren 1997, p 455)

Uganda has been one of the most successful reformers in Africa during this recent wave of globalisation, and its experience has interesting parallels with Vietnam's. It too was a country that was quite isolated economically and politically in the early 1980s. The role of trade reform in its larger reform is described in Collier and Reinikka:

Trade liberalization has been central to Uganda's structural reform program. During the 1970s, export taxation and quantitative restrictions on imports characterized trade policy in Uganda. Exports were taxed, directly and implicitly at very high rates. All exports except for coffee collapsed under this taxation. For example, tea production fell from a peak of 20,000 tons in the early 1970s to around 2,000 tons by the early 1980s, and cotton production fell from a peak of 87,000 tons, to 2,000 tons. By contrast, coffee exports declined by around one-third. Part of the export taxation was achieved through overvaluation of the exchange rate, which was propelled by intense foreign exchange rationing, but mitigated by an active illegal market. Manufacturing based on import substitution collapsed along with the export sector as a result of shortages, volatility, and rationing of import licenses and foreign exchange. President Amin's policy toward foreign investment was dominated by confiscation without compensation, and he expelled more than 70,000 people from the Asian community. In 1986 the NRM government inherited a trade regime that included extensive nontariff barriers, biased government purchasing, and high export taxes, coupled with considerable smuggling. The nontariff barriers have gradually been removed since the introduction in 1991 of automatic licensing under an import certification scheme. Similarly, central government purchasing was reformed and is now subject to open tendering without a preference for domestic firms over imports. By the mid 1990s, the import tariff schedule had five ad valorem rates between 0 and 60 per cent. For more than 95 per cent of imported items the tariff was between 10 and 30 per cent. During the latter half of the 1990s, the government implemented a major tariff reduction program. As a result, by 1999 the tariff system had been substantially rationalized and liberalized, which gave Uganda one of the lowest tariff structures in Africa. The maximum tariff is now 15 per cent on consumer goods, and there are only two other tariff bands: zero for capital goods and 7 per cent for intermediate imports. The average real GDP growth rate was 6.3 per cent per year during the entire recovery period (1986–99) and 6.9 per cent in the 1990s. The liberalization of trade has had a marked effect on export performance. In the 1990s export volumes grew (at constant prices) at an annualized rate of 15 per cent , and import volumes grew at 13 per cent . The value of noncoffee exports increased fivefold between 1992 and 1999. (Collier and Reinikka 2001)

These cases provide persuasive evidence that openness to foreign trade and investment – coupled with complementary reforms – can lead to faster growth in developing countries. However, individual cases always beg the question, how general are these results? Does the typical developing country that liberalises foreign trade and investment get good results? Cross-country statistical analysis is useful for looking at the general patterns in the data. Cross-country studies generally find a correlation between trade and growth. Among developing countries, some have had large increases in trade integration (measured as the ratio of trade to national income), while others have had small increases or even declines over the past 20 years (Figure 2). In general, the countries that have had large increases in trade, have also had accelerations in growth. This relationship persists after controlling for reverse causality from growth to trade and for changes in other institutions and policies (Dollar and Kraay 2001b). All of the cross-country studies suffer from potential problems of omitted variables and mis-specification, but they are nonetheless useful for summarising patterns in the data.

A final piece of evidence about integration and growth comes from firm-level studies and links us back to the quote from Paul Romer. Developing countries often have large productivity dispersion across firms making similar things: high-productivity and low-productivity firms co-exist and in small markets there is often insufficient competition to spur innovation. A consistent finding of firm-level studies is that openness leads to lower productivity dispersion (Haddad 1993; Haddad and Harrison 1993; Harrison 1994). High-cost producers exit the market as prices fall; if these firms were less productive, or were experiencing falling productivity, then their exits represent productivity improvements for the industry. While the destruction and creation of new firms is a normal part of a well-functioning economy, too often attention is simply paid to the destruction of firms, missing half of the picture. The increase in exits is only part of the adjustment. Granted, it is the first and most painful part of the adjustment. However, if there are not significant barriers to factor mobility or other barriers to entry, the other side is that there are new entrants. The exits are often front-loaded, but the net gains over time can be substantial.

Wacziarg (1998) uses 11 episodes of trade liberalisation in the 1980s to look at the issue of competition and entry. Using data on the number of establishments in each sector, he calculates that entry rates were 20 per cent higher among countries that liberalised compared to ones that did not. This estimate may reflect other policies that accompanied trade liberalisation such as privatisation and deregulation, so this is likely to be an upper bound of the impact of trade liberalisation. However, it is a sizable effect and indicates that there is plenty of potential for new firms to respond to the new incentives. The evidence also indicates that while exit rates may be significant, net turnover rates are usually very low. Thus, entry rates are usually of a comparable magnitude to the exit rates. Using plant-level data from Morocco, Chile and Columbia spanning several years in the 1980s, when these countries initiated trade reforms, indicates that exit rates range from 6 to 11 per cent a year, and entry rates from 6 to 13 per cent. Over time, the cumulative turnover is quite impressive, with a quarter to a third of firms having turned over in four years (Roberts and Tybout 1996, p 6).

The higher turnover of firms is an important source of the dynamic benefit of openness. In general, dying firms have falling productivity and new firms tend to increase their productivity over time (Liu and Tybout 1996; Roberts and Tybout 1996; Aw, Chung and Roberts 2000). In Taiwan, Aw et al (2000) find that within a five-year period, the replacement of low-productivity firms with new, higher-productivity entrants accounted for half or more of the technological advance in many Taiwanese industries.

While these studies shed some light on why open economies are more innovative and dynamic, they also remind of us why integration is controversial. There will be more dislocation in an open, dynamic economy – with some firms closing and others starting up. If workers have good social protection and opportunities for developing new skills, then everyone can benefit. But without such policies there can be some big losers.

I want to close this section with a nice point from the economic historians Peter Lindert and Jeffrey Williamson (2001) concerning the different pieces of evidence linking integration to growth: ‘The doubts that one can retain about each individual study threaten to block our view of the overall forest of evidence. Even though no one study can establish that openness to trade has unambiguously helped the representative Third World economy, the preponderance of evidence supports this conclusion’. They go on to note the ‘empty set’ of ‘countries that chose to be less open to trade and factor flows in the 1990s than in the 1960s and rose in the global living-standard ranks at the same time. As far as we can tell, there are no anti-global victories to report for the postwar Third World. We infer that this is because freer trade stimulates growth in Third World economies today, regardless of its effects before 1940.’ (pp 29–30)

2. Accelerated Growth and Poverty Reduction in the New Globalisers

Much of the debate about globalisation concerns its effects on poor countries and poor people. In the introduction I quoted a number of sweeping statements asserting that global economic integration is leading to growing poverty and inequality in the world. The reality of what is happening with poverty and inequality is far more complex, and to some extent runs exactly counter to what is being claimed by anti-globalists. Hence in this section I am going to focus on the trends in global poverty and inequality. Let's get the facts straight, and then we can have a more fruitful debate about what is causing the trends. The trends that I want to highlight in this section are that: (1) growth rates of the poorest countries have accelerated in the past 20 years and are higher than rich-country growth rates; (2) there was a large net decline in the number of poor in the world between 1980 and 2000, the first such decline in history; (3) measures of global inequality (such as the global Gini coefficient) have declined modestly since 1980, reversing a long historical trend toward greater inequality; (4) there is no pattern of rising inequality within countries, though there are some notable cases in which inequality has risen; and (5) there is a general pattern of rising wage inequality (larger wage increases for skilled workers relative to those of unskilled workers). It may seem that Trend #5 runs counter to Trend #4, but I will explain why it does not. Nevertheless, Trend #5 is important and helps explain some of the anxiety about globalisation in the industrial countries.

2.1 Trend #1: Poor country growth rates have accelerated

We have reasonably good data on economic growth going back to 1960 for about 125 countries, which make up the vast majority of world population. If you take the poorest one-fifth of countries in 1980 (that is, about 25 countries), the population-weighted growth rate of this group was 4 per cent per capita from 1980 to 1997, while the richest-fifth of countries grew at 1.7 per cent (Figure 3). This phenomenon of the fastest growth occurring in the poorest countries is new historically; the growth rates of these same countries for the prior two decades (1960–1980) were 1.8 per cent for the poor group and 3.3 per cent for the rich group. Data going back further in time are not as good, but there is evidence that richer locations have been growing faster than poorer locations for a long time.

Now, the adjective ‘population-weighted’ is very important. If you ignore differences in population and just take an average of poor-country growth rates, you will find average growth of about zero for poor countries. Among the poorest quintile of countries in 1980 you have both China and India, and you also have quite a few small countries, particularly in Africa. Ignoring population, the average growth of Chad and China is about zero, and the average growth of Togo and India is about zero. Taking account of differences in population, on the other hand, one would say that the average growth of poor countries has been very good in the past 20 years. China obviously carries a large weight in any such calculation about the growth of countries that were poor in 1980. But it is not the only poor country that did well. India, Bangladesh and Vietnam have also had accelerated growth and grown faster than rich countries in the recent period. A number of African economies, notably Uganda, have also had accelerated growth.

2.2 Trend #2: The number of poor people in the world has declined

The most important point that I want to get across in this section is that poverty reduction in low-income countries is very closely related to the growth rate in these countries. Hence, the accelerated growth of low-income countries has led to unprecedented poverty reduction. By poverty, we mean subsisting below some absolute threshold. Most poverty analysis is carried out with countries' own poverty lines, which are set in country context and naturally differ. In the 1990s we have more and more countries with reasonably good household surveys and their own poverty analysis. Figure 4 shows five poor countries that have benefited from increased integration, and in each case significant poverty reduction has gone hand-in-hand with faster growth. Poverty reduction here is the rate of decline of the poverty rate, based on the country's own poverty line and analysis.

China, for example, uses a poverty line defined in constant Chinese yuan . The poverty line is the amount of Chinese currency that you need to buy the basket of goods that the Chinese authorities deem the minimum necessary to subsist. In practice, estimates of the number of poor in a country such as China come from household surveys carried out by the statistical bureau, surveys that aim to measure households' real income or consumption. Most of the extreme poor in the world are peasants, and they subsist to a large extent on their own agricultural output. To look only at what money income they have would not be very relevant, since the extreme poor have only limited involvement in the money economy. Thus, what Chinese and other poverty analyses do is include imputed values for income in kind (such as own production of rice). So, a poverty line is meant to capture a certain real level of income or consumption.

Estimating the extent of poverty is obviously subject to error, but in many countries the measures are good enough to pick up large trends. In discussing poverty it is important to be clear what poverty line one is talking about. In global discussions one often sees reference to international poverty lines of either US$1 per day or US$2 per day, and I will explain how these relate to national poverty lines.

While Figure 4 shows the close relationship between growth and poverty reduction in five countries in the 1990s, it is not easy to extend the analysis to all countries in the world or back in time to 1980, because good household surveys are lacking for many developing countries. However, discussions of global poverty during this most recent era of globalisation are made easier by the fact that in 1980 a large majority of the world's poor lived in China and India, both of which have reasonably good national data on poverty. Bourguignon and Morrisson (2002) estimate that there were 1.4 billion people in the world subsisting on less than US$1 per day in 1980. Take this as a rough estimate around which there is a lot of uncertainty. Still, it is clear that at least 60 per cent of these poor were in China and India. So, what has happened to global poverty is going to depend to a very considerable extent on these two countries.

The Chinese statistical bureau estimates that the number of people with incomes below their national poverty line has declined from 250 million in 1978 to 34 million in 1999 (Figure 5). [2] Now, this Chinese poverty line is defined in constant Chinese yuan and it is possible to translate this into US dollars for the purpose of comparison with other countries. This conversion is best done with a purchasing power parity (PPP) exchange rate. This is the exchange rate between the Chinese yuan and the US dollar that would lead to the same price in the US and China for a representative basket of consumer goods. It is the normal basis for making international comparisons of living standards. Evaluated at PPP in this way, the Chinese poverty line is equivalent to about 70 US cents per day – quite a low poverty line. Using information on the distribution of income in China, it is possible to make a rough estimate of the number of people with income under a higher poverty line – for example, US$1 per day at PPP. A rough estimate of the number of people in China in 1978 consuming less than US$1 per day would be in the ballpark of 600 million. [3] It may be surprising that the number is so much larger than the estimate of 250 million living on less than 70 US cents per day. But in 1978 a large mass of the population was concentrated in the range between 70 US cents and US$1.

India's official poverty data also show a marked drop in poverty over the past two decades. India's consumption-based poverty line translates to about 85 US cents per day at PPP. By that line, the Indian statistical bureau estimates that there were 330 million poor people in India in 1977, and the number declined to 259 million in 1999. We can make a similar rough estimate of the number of poor living under a higher poverty line of US$1 per day, using information on the distribution of income in Indian surveys.

In Figure 6, I combine rough estimates of US$1 per day poverty in China and India. In 1977–78 there were somewhere around 1 billion people in these two giant countries who were subsisting on less than US$1 per day at PPP; by 1997–98 the estimated number had fallen to about 650 million (according to the estimates of Chen and Ravallion (2001)). This poverty reduction is all the more remarkable, because their combined population increased by nearly 700 million people over this period.

It is easy to quibble about specific numbers, but no amount of quibbling can get around the fact that there has been massive poverty reduction in China and India. These countries' own data and poverty analysis show large poverty reduction, using lines that are below US$1 per day. The poverty reduction using a common international line of US$1 per day would be larger.

While there has clearly been poverty reduction in Asia, it is also clear that poverty has been rising in Africa, where most economies have been growing slowly or not at all for the past 20 years. Chen and Ravallion (2001) estimate that the number of poor (consuming less than US$1 per day) in Sub-Saharan Africa increased from 217 million in 1987 to 301 million in 1998. There is not comparably good data for 1980, but we know that the region was not doing well in the 1980–1987 period. If the rate of increase of poverty was about the same in the 1980–1987 period, as in 1987–1993, then the increased poverty in Africa during the 1980–1998 period would be about 170 million people.

Any careful estimate of worldwide poverty is going to depend primarily on trends in China, India, and Sub-Saharan Africa. Putting together these trends reveals a large net decline in the number of poor since 1980. This is an important historical shift. Bourguignon and Morrisson (2002) estimate that the number of very poor people in the world (US$1 per day line) increased up through 1980 (Figure 7). Between 1960 and 1980 the number of poor grew by about 100 million. Between 1980 and 1992, however, the number of poor fell by about 100 million in their estimate. Chen and Ravallion (2001) use a different methodology to estimate a further decline of about 100 million between 1993 and 1998. The same study found an increase in global poverty between 1987 and 1993, which may seem at odds with the Bourguignon-Morrisson results. However, a look back at Figures 5 and 6 reveals that the poor in China and India combined have done well over the past 20 years, except for the period from 1987 to 1993, when poverty in China and India temporarily rose . During that period India had a macroeconomic crisis and a sharp recession, and in China the growth of rural incomes slowed significantly.

Indian data for 1999/2000 show further declines that have not been incorporated in the global estimates for 1997/98. Based on the well-documented poverty reduction in China and India, and their weight in world poverty, we can be confident that 200 million is a conservative estimate of the poverty reduction since 1980. In many ways, however, adding up the good experiences and the bad experiences conceals more than it reveals. Certainly it is good news that large poor countries in Asia have done well (not just China and India, but Bangladesh and Vietnam as well). But that is no consolation to the growing number of poor in Africa, where economies continue to languish (with the occasional bright spot such as Uganda).

2.3 Trend #3: Global inequality has declined (modestly)

People use the phrase ‘global inequality’ casually to mean a number of different things. But the most sensible definition would be the same one we use for a country: line up all the people in the world from the poorest to the richest and calculate a measure of inequality among their incomes. There are a number of possible measures, of which the Gini coefficient is the best known. Xavier Sala-i-Martin (2002) finds in a new paper that any of the standard measures of inequality show a decline in global inequality since 1980. Subjectively, I would describe this as a modest decline, and one about which we do not have a lot of statistical confidence. But, even if global inequality is flat, it represents an important reverse of a long historical pattern of rising global inequality and contradicts the frequent claims that inequality is rising.

Bourguignon and Morrisson (2002) calculate the global Gini measure of inequality going back to 1820. Obviously we do not have a lot of confidence in these early estimates, but they illustrate a point that is not seriously questioned: global inequality has been on the rise throughout modern economic history. The Bourguignon-Morrisson estimates of the global Gini have it rising from 0.50 in 1820 to about 0.65 around 1980 (Figure 8). Sala-i-Martin estimates that the global Gini has since declined to 0.61. Other measures of inequality such as the Theil index or the mean log deviation show a similar decline. The latter measures have the advantage that they can be decomposed into inequality among countries (differences in per capita income across countries) and inequality within countries. What this decomposition shows is that most of the inequality in the world can be attributed to inequality among countries (Figure 9). Global inequality rose from 1820 to 1980 primarily because regions already relatively rich in 1820 (Europe, North America) subsequently grew faster than poor locations. As noted above (Trend #1), that pattern of growth was reversed starting around 1980, and the faster growth in poor locations such as China, India, Bangladesh and Vietnam accounts for the modest decline in global inequality since then. (Slow growth in Africa tended to increase inequality, faster growth in low-income Asia tended to reduce it, and the latter outweighed the former, modestly.) [4]

Thinking about the different experiences of Asia and Africa, as in the last section, helps give a clearer picture of what is likely to happen in the future. Rapid growth in Asia has been a force for greater global equality because that is where the majority of the world's extreme poor lived in 1980 and they benefited from the growth. However, if the same growth trends persist, they will not continue to be a force for equality. Sala-i-Martin projects future global inequality if the growth rates of 1980–1998 persist: global inequality will continue to decline until the year 2015 or 2020 (depending on the measure of inequality), after which global inequality will rise sharply (Figure 10). A large share of the world's poor still live in India and other Asian countries, so that continued rapid growth there will be equalising for another decade or so. But more and more, poverty will be concentrated in Africa, so that if its slow growth persists, global inequality will eventually rise again.

2.4 Trend #4: There is no general trend toward higher inequality within countries; in particular, among developing countries inequality has decreased in about as many cases as it has increased

The analysis immediately above shows that inequality within countries plays a relatively small role in measures of global income inequality. Nevertheless, people care about trends in inequality in their own societies (arguably more than they care about global inequality and poverty). So, a different issue is, what is happening to income inequality within countries? One of the common claims about globalisation (see the quotes in the introduction) is that it is leading to greater inequality within countries and hence fostering social and political polarisation.

To assess this claim Aart Kraay and I (Dollar and Kraay 2001a) collected income distribution data from over 100 countries, in some cases going back decades. We found first of all that there is no general trend toward higher or lower inequality within countries. One way to show this is to look at the growth rate of income of the poorest 20 per cent of the population, relative to the growth rate of the whole economy. In general, growth rate of income of the poorest quintile is the same as the per capita growth rate (Figure 11). This is equivalent to showing that the bottom quintile share (another common measure of inequality) does not vary with per capita income. We found that this relationship has not changed over time (it is the same for the 1990s as for earlier decades). In other words, some countries in the 1990s had increases in inequality (China and the US are two important examples), while other countries had decreases. We also divided the sample between rich and poor countries to explore a Kuznets-type relationship (or, equivalently, included a quadratic term) and found that income of the poor tends to rise proportionately to per capita income in developing countries, as well as in rich ones.

Most important for the debate about globalisation, we tried to use measures of integration to explain the changes in inequality that have occurred. But changes in inequality are not related to any of these measures of integration. For example, countries in which trade integration has increased show rises in inequality in some cases and declines in inequality in others (Figure 12). So too for other measures such as tariff rates or capital controls. Figure 4 showed five good examples of poor countries that have integrated actively with the world economy: in two of these (Uganda and Vietnam) income distribution has shifted in favour of the poor during integration, which is why poverty reduction has been so strong in these cases. In low-income countries in particular much of the import protection was benefiting relatively rich and powerful groups, so that integration with the global market can go hand-in-hand with declines in income inequality.

While it is true that there is no general trend toward higher inequality within countries when looking at all the countries of the world, the picture is not so favourable if one looks only at rich countries and only at the last decade. The Luxembourg Income Study (LIS) has produced comparable, high-quality income distribution data for most of the rich countries. This work finds no obvious trends in inequality up through the mid to late 1980s. Over the past decade, on the other hand, there have been increases in inequality in most of the rich countries. Because low-skilled workers in these countries are now competing more with workers in the developing world, it is certainly plausible that global economic integration creates pressures for higher inequality in rich countries, while having effects in poor countries that often go the other way. The good news from the LIS studies is that ‘[g]lobalisation does not force any single outcome on any country. Domestic policies and institutions still have large effects on the level and trend of inequality within rich and middle-income nations, even in a globalising world…’ (Smeeding, this volume, p 179). In other words, among rich countries some have managed to maintain stable income distributions in this era of globalisation through their social and economic policies (on taxes, education, welfare).

2.5 Trend #5: Wage inequality is rising worldwide

Much of the concern about globalisation in rich countries relates to workers and what is happening to wages and other labour issues. The most comprehensive examination of globalisation and wages used International Labour Organisation data on very detailed occupational wages going back two decades (Freeman, Oostendorp and Rama 2001). These data look across countries at what is happening to wages for very specific occupations (bricklayer, primary school teacher, nurse, auto worker). What the study found is that wages have generally been rising faster in globalising developing countries than in rich ones, and faster in rich ones than in non-globalising developing countries (Figure 13). [5] However, their detailed findings are far more complex. First, there is a timing issue. Trade liberalisation is often associated with reduced wages initially, followed by increases past the initial level. Second, foreign direct investment (FDI) is very strongly related to wage increases, while trade has a weaker relationship. Locations that are able to attract FDI are the ones that have had the clearest gains for workers (examples would be northern Mexico, China, Vietnam), whereas countries that liberalise trade and get little foreign investment see weaker benefits. Finally, the gains are relatively larger for skilled workers. This finding is consistent with other work showing that there has been a worldwide trend toward greater wage inequality – that is, a larger gap between pay for educated workers and pay for less educated/skilled workers.

If wage inequality is going up worldwide, how can it be that income inequality is not rising in most countries? There are several reasons why these two trends are not inconsistent. Most important, in the typical developing country wage earners are a tiny fraction of the population. Even unskilled wage workers are a relatively elite group. Take Vietnam as an example, a low-income country where we have a survey of the same representative sample of households early in liberalisation (1993) and five years later. The majority of households in the sample and in the country are peasants. What we see in the household data is that the price of the main agricultural output (rice) went up dramatically while the price of the main purchased input (fertiliser) actually went down. These price movements are directly related to globalisation, because over this period Vietnam became a major exporter of rice (supporting its price) and a major importer of fertiliser from cheaper producers (lowering its price). The typical poor family got a much bigger ‘wedge’ between its input price and output price, and their real income went up dramatically (Benjamin and Brandt 2002). So, one of the most important forces acting on income distribution in this low-income country has nothing to do with wages.

Quite a few rural households also sent a family member to a nearby city to work in a factory for the first time. I worked on Vietnam for the World Bank from 1989 to 1995, and one of the issues that I covered was the manufacturing sector. When I first started visiting factories in the summer of 1989, the typical wage in local currency was the equivalent of US$9 per month. Now, factory workers making contract shoes for US brands often make US$50 per month or more. So, the wage for a relatively unskilled worker has gone up something like five-fold. But wages for some of the skilled occupations – say, computer programmer or English interpreter – may have gone up 10 times or even more. Thus, a careful study of wage inequality is likely to show rising inequality. However, how wage inequality translates into household inequality is very complex. For a surplus worker from a large rural household who gets one of the newly created jobs in a shoe factory, earnings go from zero to US$50 per month. Thus, if a large number of new wage jobs are created and if these typically pay a lot more than people earn in the rural or informal sector, then a country can have rising wage inequality but stable or even declining income inequality (in Vietnam the Gini coefficient for household income inequality actually declined between 1993 and 1998). In rich countries, on the other hand, where most people are wage earners, the higher wage inequality is likely to translate into higher household income inequality, which is what we have seen over the past decade.

A third point about wage inequality and household income inequality that is relevant for rich countries is that measures of wage inequality are often made pre-tax. If the country has a strongly progressive income tax, then inequality measures from household data (which are often post-tax) do not have to follow wage inequality, pre-tax. Tax policy can offset some of the trends in the labour market.

Finally, there is the important issue that households can respond to increased wage inequality by investing more in the education of their children. A higher economic return to education is not a bad thing, provided that there is fair access to education for all. In Vietnam, there has been a tremendous increase in the secondary school enrolment rate in the 1990s (from 32 to 56 per cent). This increase partly reflects the society's and the government's investment in schools (supported by aid donors), but more children going to school also reflects households' decisions. If there is little or no perceived return to education, it is much harder to get families in poor countries to send their children to school. Where children have decent access to education, a higher skill premium stimulates a shift of the labour force from low-skill to higher-skill occupations.

From this discussion it is easy to see why some labour unions in rich countries are concerned about integration with the developing world. It is difficult to prove that the integration is leading to this greater wage inequality, but it seems likely that integration is one factor. Concerning the immigration side of integration, Borjas, Freeman and Katz (1997) estimate that flows of unskilled labour into the US have reduced wages for such labour by 5 per cent from where they would be otherwise. The immigrants who find new jobs earn a lot more than they did before (10 times as much in one study), but their competition reduces wages of the US workers who were already doing such jobs. Similarly, imports of garments and footwear from countries such as Vietnam and Bangladesh create jobs for workers there that pay far more than other opportunities in those countries, but put pressure on unskilled wages in the rich countries.

Thus, overall the era of globalisation has seen unprecedented poverty reduction and probably a modest decline in global inequality. However, it has put real pressure on less-skilled workers in rich countries, and this competitive pressure is a key reason why the growing integration is controversial in the industrial countries and why there is a significant political movement to restrict the opportunities of poor countries. More generally, the integration causes disruption in both rich countries and poor ones. Some people are thrown out of work, some capitalists lose their investments; in the short run there are clearly winners and losers. To some extent the extreme claims of anti-globalists that integration is leading to higher inequality across and within countries – claims that are not borne out by the evidence – distract attention from the real issues. Globalisation is disruptive, it produces relative winners and losers, and there are public policies that can mitigate these bad effects (social protection, investment in education). The key policy issue is whether to try to mitigate the bad effects of integration or to roll back integration.

3. Making Globalisation Work Better for the Poor

What are the implications of these findings – for developing countries, for rich countries, and for non-government organisations that care about global poverty? So far, the most recent wave of globalisation starting around 1980 has been a powerful force for equality and poverty reduction. But it would be naïve to think that this will inevitably continue.

Whether global economic integration continues to be an equalising force will depend on the extent to which poor locations participate in this integration, and that in turn will depend on both their own policies and the policies of the rich world. True integration requires not just trade liberalisation, but also wide-ranging reforms of institutions and policies. If we look at some of the countries that are not participating very strongly in globalisation, many of them have serious problems with the overall investment climate: Kenya, Pakistan, Burma and Nigeria would all be examples. Some of these countries also have restrictive policies toward trade, but even if they liberalise trade not much is likely to happen without other measures. It is not easy to predict the reform paths of these countries. (If you think about some of the relative successes that I have cited – China, India, Uganda, Vietnam – in each case their reform was a startling surprise.) As long as there are locations with weak institutions and policies, people living there are going to fall further and further behind the rest of the world in terms of living standards.

Building a coalition for reform in these locations is not easy, and what outsiders can do to help is limited. But one thing that the rich countries can do is to make it easy for developing countries that do choose to open up, to join the club. Unfortunately, in recent years the rich countries have been making it harder for countries to join the club of trading nations. The GATT was originally built around agreements concerning trade practices. Now, however, a certain degree of institutional harmonisation is required to join the World Trade Organisation (WTO) (for examples, on policies toward intellectual property rights). The proposal to regulate labour standards and environmental standards through WTO sanctions would take this requirement for institutional harmonisation much farther. Power in the WTO is inherently unbalanced: size matters in the important area of dispute settlement where only larger countries can effectively threaten to retaliate against illegal measures. If the US wins an unfair trade practices case against Bangladesh it is allowed to impose punitive duties on Bangladeshi products. Owing to the asymmetry in the size of these economies the penalties are likely to impose a small cost on US consumers and a large one on Bangladeshi producers. Now, suppose the situation is reversed and Bangladesh wins a judgment against the US. For Bangladesh to impose punitive duties on US products is likely to hurt its own economy much more than the US. Thus, developing countries see the proposal to regulate their labour and environmental standards through WTO sanctions as inherently unfair and as a new protectionist tool that rich countries can wield against them.

So, globalisation will proceed more smoothly if the rich countries make it easy for developing countries to benefit from trade and investment. Reciprocal trade liberalisations have worked well throughout the post-war period. There still are serious protections in OECD countries against agricultural and labour-intensive products that are important to developing nations. It would help substantially to reduce these protections. At the same time, developing countries would benefit from further openings of their own markets. They have a lot to gain from more trade in services. Also, 70 per cent of the tariff barriers that developing countries face are from other developing countries. So, there is a lot of potential to expand trade among developing countries, if trade restrictions were further eased. However, the trend to use trade agreements to try to impose an institutional model from the OECD countries on Third World countries makes it more difficult to reach trade agreements that benefit poor countries.

Another reason to be pessimistic concerns geography. There is no inherent reason why coastal China should be poor – or southern India, or Vietnam, or northern Mexico. These locations historically were held back by misguided policies, and with policy reform they can grow very rapidly and take their natural place in the world income distribution. However, the same reforms are not going to have the same effect in Mali or Chad. Some countries have poor geography in the sense that they are far from markets and have inherently high transport costs. Other locations face challenging health and agricultural problems. So, it would be naïve to think that trade and investment can alleviate poverty in all locations. Much more could be done with foreign aid targeted to developing medicines for malaria, AIDS, and other health problems of poor areas and to building infrastructure and institutions in these locations. The promises for greater aid from the US and Europe at the Monterrey Conference were encouraging, but it remains to be seen if these promises are fulfilled.

The importance of geography also raises the issue of migration – the missing flow in today's globalisation. Migration from locations that are poor because of either weak institutions and/or difficult physical geography could make a large contribution to reducing poverty in the lagging regions. Most migration from South to North is economically motivated. This migration raises the living standard of the migrant and benefits the sending country in three ways – reducing the labour force raises wages for those who remain behind, migrants typically send a large volume of remittances back home, and their presence in the OECD economy can support the development of trade and investment networks. These benefits are strongest if the migrant is relatively unskilled, since this is the part of the labour force that is in over-supply in much of the developing world.

Each year 83 million people are added to world population, 82 million of these in the developing world. Furthermore, populations in Europe and Japan are ageing and the labour forces there will begin to shrink without more migration. So, there are clear economic benefits to more migration of unskilled workers from the South to the North, and yet this flow remains highly restricted and very controversial because of its impact on society and culture. Because the economic pressures are so strong, however, growing volumes of illegal immigration are taking place – and some of the worst abuses of ‘globalisation’ occur because we are not globalised when it comes to labour flows.

Realistically, none of the OECD countries is going to adopt open migration. But there is a good case to be made to revisit migration policies. Some of the OECD countries have a strong bias in their immigration policies toward highly skilled workers, spurring ‘brain drain’ from the developing world. This policy pushes much of the unskilled flow into the illegal category. If OECD countries would accept – legally – more unskilled workers, it should help with their own looming labour shortages, improve living standards in sending countries, and reduce the growing illegal human trade with all of its abuses.

So, integration of poor economies with richer ones has provided many opportunities for poor people to improve their lives. Examples of the beneficiaries of globalisation will be found among Mexican migrants, Chinese factory workers, Vietnamese peasants and Ugandan farmers. Lots of non-poor in developing and rich countries alike also benefit, of course. But much of the current debate about globalisation seems to ignore the fact that it has provided many poor people in the developing world unprecedented opportunities. After all of the rhetoric about globalisation is stripped away, many of the practical policy questions come down to whether we are going to make it easy for poor communities that want to integrate with the world economy to do so, or whether we are going to make it difficult. The world's poor have a large stake in how the rich countries answer these questions.

Development Research Group, World Bank. Views expressed are those of the author and do not necessarily reflect official views of the World Bank, its Executive Directors, or its member countries. [1]

This estimate is only for the rural population of China. However, the available survey data show that there were almost no urban families living under this poverty line, either in 1980 or today. So, the estimate can be taken as a reasonable approximation of overall extreme poverty in China. [2]

The mean income in the rural household survey in China, converted into 1993 US dollars with the Summers and Heston PPP exchange rate, is about US$200 per year in 1978. Using the information on the distribution of income in the 1981 sample, the earliest available, the estimated number of people in China with income less than US$1 per day would be as high as 750 million. The number consuming less than US$1 per day would be smaller, since even the very poor have some savings in China. Also, the early surveys may not have done a good job with imputed consumption from housing and other durables. For these reasons I take 600 million as a rough but conservative estimate of the number of poor (consuming less than US$1 per day) at the beginning of China's economic reform. [3]

Milanovic (2002) estimates an increase in the global Gini coefficient for the short period between 1988 and 1993. How can this be reconciled with the Sala-i-Martin findings? Global inequality has declined over the past two decades primarily because poor people in China and India have seen increases in their incomes relative to incomes of rich people (that is, OECD populations). If you refer back to Figure 6, you will see that the period from 1988 to 1993 was the one period in the past 20 years that was not good for poor people in China and India. [4]

Dollar and Kraay (2001b) divide developing countries into more globalised and less globalised; the more globalised are the top one-third of developing countries in terms of increases in trade to GDP between the late 1970s and the late 1990s. The Freeman, Oostendorp and Rama study uses this classification. [5]

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References:

• Bhagwati, Jagdish N. (2007). In defence of globalization. Oxford University Press.
•  Globalization Issue. (2005). Globalization Issues. http://www. independence. co. uk/publicationslist/157-theproblemofglob. html

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