The Royal Society of Edinburgh (RSE) is pleased to respond to the House of Lords Select Committee on Economic Affairs Inquiry into the Global Economy. The RSE is Scotland’s premier Learned Society, comprising Fellows elected on the basis of their distinction, from the full range of academic disciplines, and from industry, commerce and the professions. This response has been compiled by the General Secretary with the assistance of a number of Fellows with substantial experience in economics and business.

Summary

The Select Committee’s inquiry into the global economy is important and timely. The linkage of markets across national boundaries may lead to a change in the balance of interests served by the economy and increase the power of large producer interests, at the expense of the degree of competition and diversity available in the markets; and potentially against consumer interests and the smooth functioning of the economy, in terms of growth and employment. The key points identified by the RSE include:

• Economic integration and globalisation, are not the same things. An open and integrated world economy is a necessary condition for globalisation but in addition it requires imperfect competition, sufficient links between producers and sufficient labour and capital mobility in the production process, to be a matter of concern. 
• Globalisation is a continuous process, and has been around a long time. However, the reduction in transport costs plus the increase in communications speeds mean that globalisation is feasible and profitable on a much wider and deeper scale. 
• The drivers of globalisation are more open and liberal markets, the significant reduction in freight costs, resource optimisation and the development of alliances.
• Regulation of globalisation for the purpose of constraining abuse as well as efforts to offset such defects should be undertaken so long as they are specific and their outcome is measurable. 
• A growing rich/poor divide amongst nations will be increasingly apparent, provoking tension between gainers and losers. There is, therefore, a need to build bridges across this divide, without which globalisation could bring more problems than benefits. 

The specific issues identified in the call for evidence are addressed below:

How should economic globalisation be defined? Does it mean anything different from an open and integrated world economy? If so, what?
An open and integrated world economy is a necessary condition for globalisation but it is not sufficient. Globalisation requires certain other conditions to hold as well. First it requires imperfect competition, or at least the potential for a less than perfectly competitive market or institutional structure in the markets and industries where it appears. This is because it is not just the linkage of markets across national boundaries which causes the concern about globalisation and makes an enquiry such as this necessary. Instead it is the fact that such linkages may lead to a change in the balance of interests served by the economy; increasing the power of (large) producer interests, at the expense of the degree of competition and diversity available in the markets; and potentially against consumer interests and the smooth functioning of the economy, in terms of growth and employment. In addition, to the extent that productive capacity and ownership is not spread evenly over countries/regions of the world or sectors of society, this aspect of globalisation can alter the balance of power between nations; between developed and less developed nations; or between rich and poor within society.

Secondly, globalisation requires sufficient links between producers. This is in terms of physical links "upstream" and "downstream" in the production process as well as across national borders; financing and ownership links (as part of the production process); and a community of interest among producers in terms of free market access, market deregulation and cost minimisation which their production links would make them seek. Thirdly, globalisation requires sufficient factor mobility (i.e. labour and capital) in the production process, so that firms can potentially move their production to the more favourable location (or labour, likewise, to the most favourable wage or tax environment; or to where jobs are being created).

Hence, economic integration and globalisation, are not the same thing. One implies the other, but not necessarily vice versa. However, the interconnections between firms "upstream and downstream" and via the international capital markets would normally mean that they would acquire the coincidence of interests and the characteristics which allow them to exploit market power, even if they themselves were working in a perfectly competitive environment. Consequently there is likely to be little difference in practice between increasing (international) integration and globalisation. Nevertheless, globalisation, in as far as it has its own impacts on the national economy, and the UK or world institutions, or the need for new policies or regulation, requires greater market integration (directly or indirectly) plus certain market or institutional structures which give the producers some influence over the development of their markets. If this were not the case globalisation would not be an issue since economic integration would simply mean competition, and choice would be expanded for producer and consumer alike.

Is globalisation a new phenomenon or just a new label?
Globalisation is a continuous process, and has been around a long time. It would have been evident in the Roman Empire, and in our own colonial period. It could be argued that the difference now is that the arbitrary political "preference" element has been removed so that it is purely a matter of commercial logic. However, the pressure which the Non Government Organisations (NGOs) have been able to bring to bear on the International Monetary Fund (IMF), European Commission and World Bank suggest that many people still see globalisation as following US and European commercial and political interests. Secondly, the reduction in transport costs plus the increase in communication speeds mean that globalisation is feasible and profitable on a much wider and deeper scale. Many more people are, therefore, directly affected by it than in the past and it may be possible to sustain a much greater divergence in interests between the multinationals and local companies/governments/employees than previously. Another contributing factor is the greater complexity in the production process, which allows a more extensive network of links with other firms elsewhere.

Should the main focus be what is called the real economy or the financial economy?
The separation of the real and the financial economy would be a false division in the context of globalisation. The growth of global companies, in terms of the output of goods and services, has implications for the integration of financial markets. The real economy is also driving globalisation and the financial economy will facilitate competitive advantage, curb it or even distort it.

How does globalisation impact on the UK economy, and how does it impact on UK national and international policy making?
Globalisation generates a diverse range of opportunities for the trade of goods and services and thereby promotes their production. Consequently, expanding globalisation broadens and multiplies those opportunities, while a growing world economy expands their value. However, when the parameters turn negative, then the converse will apply both in terms of individual industries and the stock and bond markets.

Integration can also cause risk and volatility because in any one market there will now be additional (foreign) sources of shocks or random behaviour. If, on the other hand, globalisation causes economies to diversify, volatility from abroad may be reduced. Globalisation can also impose constraints on economic policy, for examplehigh corporation taxes could drive away global companies.

How does globalisation affect the major world economic institutions?
Given that globalisation has always been with us, the difference between today and yesterday is that the World economy and globalisation have been expanding at an accelerating rate. The effect has been to challenge the world institutions, such as the IMF and World Trade Organisation (WTO), to keep up. Not surprisingly, each is exhibiting signs of stress in seeking to do this.

Superimposed on these institutions, there are powerful world economic groupings (such as the US Government, the EU and the Japanese Government) which can heavily influence both the scope of globalisation as well as who will be the beneficiaries. Global companies can also have sufficient weight to influence governments to negotiate in their interest.

Does globalisation require regulation and, if so, is this possible at the national level, or will the need for international regulation be reinforced?
Regulation of globalisation for the purpose of constraining abuse as well as efforts to offset such defects should be undertaken so long as they are specific and their outcome is measurable. This is only likely to be achievable at international level, possibly through domestic regulators (e.g. competition regulators in the EC and the US) operating under similar guidelines, or possibly through supra-national organisations such as the Basle agreements on regulatory requirements for banks.

What are the driving forces causing globalisation? Are they chiefly real or financial?
Historically, multi-national companies located production abroad to overcome natural or artificial trade barriers in servicing their customers cost effectively on-time. Multinationals created overseas production sites to meet local consumption. However, these driving forces have disappeared and creating overseas production sites in order to meet local consumption is no longer a driver for foreign investment. This is due to a number of factors:

More open and liberal markets: The most potent driver is the impact of increasing openness in the world economy which is promoting the seeking out and exploitation of competitive advantage. Tariffs on imports of manufacturers are declining rapidly and there have been liberalising changes in regulations governing foreign investment. The most important catalyst in this process has been the creation of free trade zones like the European Union’s single market, the North American Free Trade Agreement in the Americas and the Asia Pacific Economic Co-operation in the Asian markets.

Significant reduction in freight costs: Supporting the growing integration of the world economy are the reduced cost and increased efficiency of transportation and communications. There have been significant reductions in air transport costs, and the unit cost of sea freight has fallen by around 70% in real terms over the past 15 years.

Resource optimisation: Global companies selling into a multitude of country markets and each measuring its market share in global terms, will place production facilities wherever costs are lowest. Companies are restructuring their organisations to service their markets and customer demands. The regional infrastructure which historically tended to replicate the parent organisation is obsolete, and multinationals are now creating widely spread networks of focussed centres of excellence of Research and Development, Component Production, Assembly and Distribution, optimising the best use of world-class resources.

Alliances: Increasingly companies are also seeing alliances as an alternative to the risk and expense of acquisition. The pressure to compete globally on all fronts is forcing companies to build partnerships, even with competitors, and the rate of global acquisitions and alliances is increasing rapidly and is currently estimated at 20% per annum and growing.

How are firms changing their business methods and the international location of their activities? What are the implications of any change?
Globalisation may affect the pattern of production and hence the economic structures of the economies involved. If there are barriers to commerce between countries or regions - be they restrictions on trade, or financial risk barriers, or uncertainties about future prices, exchange rate values, or asset values - then firms will wish to set up in each country or region because it will be cheaper to supply locally from there. But if these barriers get removed, for example, through a single market or free trade programme or with a single currency or exchange rate stabilisation mechanism, then firms will tend to relocate in one or two places only. It will be cheaper for them to supply from one or two strategically located plants because of the cost advantages of scale economies and the efficiency advantages of comparative advantage, without risking price, costs or exchange rate fluctuations that might otherwise have upset their calculations. Therefore, as any of these barriers fall, globalisation and specialisation of production and services in different regions/countries occur.

In terms of the implications of these changes, if capital or labour can migrate, then these agglomeration effects will be intensified as workers and/or capital seek the higher wages/rates of return. Restructuring (and retraining) will be a likely consequence and only if workers are insensitive to these wage differentials (or if the wage differentials are taken away), for example, because of untransferable social security benefits, or other costs of moving, will firms start to spread out again.

Market flexibility and reform will, therefore, become key in creating "locational completion" in a globalising economy. In addition, those businesses which rely upon low "value added", especially when in association with a relatively high labour content, will have a limited life. There will be exceptions due to local requirements or geography, or as a consequence of local protection. However, ultimately such artificial environments will be influenced by the pervasive demands of competitive advantage. In these circumstances, competitive advantage will derive from ever increasing innovation, from constantly upgraded skills and from progressive and effective management. Governments seeking to retain/attract manufacturing to their countries will be in a weaker bargaining position.

Has globalisation affected goods and services differently?
Globalisation, by its nature, affects tradables more than non-tradables. Up to now, these circumstances have tended to impact first on the manufacture of goods, with services being more tied to the market being serviced. Certain exceptions, however, are already apparent with banking, insurance, accountancy and consultancy having extended their reaches at a swift pace over the past decade. Therefore, it is important to stress that globalisation applies to the inputs to the production process, as well as to the outputs and to the consumers. One feature of globalisation, which is common to both goods and services, is brands. Globalisation is providing strong brands with the opportunity to further strengthen their brand and thus the potential of greater monopoly power.

How is globalisation affecting employment (a) in the UK, (b) more generally in the advanced world, and (c) in the developing world? What are the implications for skill structure, job security and income distribution?
Globalisation makes job security much less certain, whether in the UK or elsewhere in the industrial world, because global companies can readily switch operations to other sites and other countries. Globalisation has also diminished employment opportunities for unskilled and poorly skilled workers in advanced countries, whose productivity is too low to compete, even at minimum advanced country wage rates, with much less highly paid workers in developing countries. Employment opportunities for workers in the developing world are, therefore, correspondingly increased.

Employment in the UK and other advanced economies is, therefore, demanding a more flexible labour force and the development of skills that are transferable across industries. The implications for all are that huge investment will be required to progressively "up-skill", with competitive advantage depending upon the quality, quantity and diversity of the skills available. In addition, job security will not mean long term employment with one employer but the ability to move easily from one job to another. The income gap between the less able or skilled and the others will also widen both within countries and between countries, as people with skills that are scarce in international terms are able to sell their services more dearly, while those with poor skills have difficulty in marketing them at all.

Who are the gainers and who are the losers?
The gainers will be those communities and countries which repeatedly over time get the skill equation right and the losers will be those which do not. Individually, the gainers will be those who are well-trained and well-educated with internationally marketable skills, and the losers will be those who are unskilled, unadventurous and immobile.

Disadvantaged communities will be vulnerable to falling further behind. Disadvantage in these circumstances will inevitably have increasingly serious social repercussions. By extension, the same will apply between countries and the effect of improving international communications will be that a growing rich/poor divide will be increasingly apparent, provoking tension between gainers and losers. There is, therefore, a need to build bridges across this divide, without which globalisation could bring more social problems than benefits.

How will globalisation affect product market competition and consumer choice? How dominant are the transnational corporations? Is their dominance growing?
Transnational corporations have become more dominant and certain brands have achieved transnational pre-eminence. However, economic blocks, such as the US and the EU, have anti-trust legislation which should ensure that the extent of their dominance does not restrict free trade. So long as the main sources of transnational corporations are subject to vigilant anti-trust monitoring, no dominance by any one product is likely to grow to the point of adversely affecting trade.

What is the connection between globalisation and the communications revolution?
The communications revolution has made it easier to access markets from a distance and reduce selling costs. It has increased the importance of information processing systems, which have a relatively high fixed and low variable cost, and is one example of the economies of scale that have contributed to globalisation. At the same time, these developments are themselves stimulated by the potential of globalisation and the demand upon which it is founded.

What is the connection between globalisation and labour mobility?
Given that competitive advantage is a driving force behind globalisation, globalisation will make labour mobility more necessary, implying the need for the general improvement in skills and an absence of national barriers to immigration. However, this is one area of globalisation which is most influenced by national, cultural and linguistic factors, as any one of these has the capability to restrict labour movement. To the extent that labour mobility is constrained, so the pace of globalisation will be decreased and the benefits from it deferred.

Does it matter to a nation who owns its companies, including UK banks and financial markets such as the London Stock Exchange?
Ownership should not matter in purely commercial terms, whereas location most definitely does. However, the location of higher level functions is usually associated with the location of top decision-takers, who tend to be in the country of ownership. The interests of the residents of a country weigh more heavily if the owners also reside there, therefore, in an economic downturn, unless they suffer from major cost disadvantages, it is rare for core sites to be closed down whilst peripheral sites remain open. In addition, core sites have a better chance of being involved in new product development, on which the future prosperity of a company depends. However, neither London nor Edinburgh are less strong as financial centres because key segments of them are "owned" from elsewhere. It is the conservative, relatively heavily regulated and "closed" financial centres have tended to suffer (e.g. Scandinavia, France, parts of Germany and the US before deregulation).

How significant is global banking? What role should the government play in determining the capital adequacy of international banks present in London?
Global banking is highly significant because it plays a key part in the international integration of capital markets. It helps to ensure that financial conditions in individual countries are strongly influenced by conditions in the world at large. The government should continue to influence the internationally-agreed capital adequacy regime through participation in the international bodies attempting to develop international agreements on capital adequacy and liquidity risk ratios for financial institutions. It is strong prudential supervision and a liberal market order that makes a financial market place attractive.

Are capital and money markets more interdependent than before? Are international capital flows too volatile? Is international financial instability increasing? Has market uncertainty increased?
The capital and money markets are more interdependent and the correlation between movements in national markets has increased. In the light of all that has been said above, it is also highly desirable that this should be the case. As to the volatility of capital flows, if everything in the system is speeding up, in large part because technology is accelerating the process, then there will be increasing volatility as financial resources seek to flow to where the advantages are perceived to lie. This is not necessarily bad, especially as the corollary would be a slower response rate to factors in the world economy which are themselves moving at an ever faster rate.

It is difficult to say whether instability is increasing but new financial instruments (e.g. hedge funds) and markets give greater weight to "information-traders", whose views may tend to move together, as opposed to "liquidity-traders", whose actions are based upon their liquidity positions and needs. The new instruments and markets are also conducive to traders taking geared positions and one-way information-trading allied to geared positions is likely to increase instability. However, there has not been a major banking failure with international implications for some time and the way in which the Russian debt crisis and the failure of Long Term Capital Management in 1998 were handled suggests that the system is capable of dealing with crises at least of this magnitude. Market uncertainty does seem to have increased as measured by the volatility of share prices. However, the availability of information and constant efforts to achieve transparency in commercial maters now allow for better informed judgements to be made.

Is it important that individuals (and companies and pension funds) should be allowed unlimited access to international capital markets?
There is no doubt that unfettered access does allow investors to construct portfolios that have a higher degree of stability for any given return than would be the case if they were confined to domestic markets. But short of leaving the EU, re-introducing exchange control, and constraining the activities of all UK-based transnational companies, there is no realistic prospect of blocking access to other markets effectively.

What UK government policy responses are required in areas including education and infrastructure investments, social safety nets, and the regulation of financial and other markets?
In the areas of education and infrastructure, a key concern of Government policy should be to ensure that investments are made that will enhance the ability of the UK to assert an improving competitive capability, through investing in education and skills to make the labour force more competitive in international terms as well as raising the standard of transport and communications infra-structure.

On social safety nets, a natural reaction to globalisation, and the greater variability in job security and/or incomes, is to seek ways of generating employment or wage "insurance". There is plenty of evidence that governments typically attempt to create such "insurance" by regulating the labour markets through an increased social safety net, restrictive employment regulations, greater hiring/firing costs, minimum wage or shorter working week regulations. However, that is likely to generate more inflexible labour markets, and hence higher unemployment in the long run, even if it does succeed in providing some "insurance"/security in the short term. A more successful long-term strategy could be to take measures to make the labour markets more flexible. Although this may mean more frequent adjustments (or periods of unemployment and lower wages) in the short term, it would enable people to better maintain their wages or jobs over the longer term. The measures needed here would be market deregulation, supply side reforms, greater education and training, and reduced employment costs (e.g. payroll taxes). Nevertheless, Government policy has a requirement, if not a duty, that those who are genuinely disadvantaged are looked after within the resources the society can make available for this purpose.

On the regulation of financial and other markets, there should be vigilance in competition policy and a drive wherever possible towards international harmonisation, as well as ensuring transparency and the encouragement of as free an enterprise system as is practical.

Bearing in mind the last of the broad questions listed above, what part should international organisations, such as the IMF, the World Bank, the WTO, play in the regulation of globalisation? Should their roles be changed in any respect?
There are a great number of financially sophisticated economies and there are many giant corporations with huge resources which trade in most countries of the world. However, there are also a great number of disconnected, dysfunctional and vulnerable economies. The aspiration to have a truly global economy and to pursue globalisation must be linked in some measure to addressing the issues of the poorest and most troubled, and not solely to open up increasingly wider gaps between the already strong and the often hopelessly weak.

The WTO has a crucial role in ensuring that the international trading regime does not give undue advantage to large global companies at the expense of smaller competitors, while the IMF and World Bank have other tasks than regulating globalisation but could play a role in addressing the gaps between strong and weak economies. The IMF should also set standards for capital adequacy and prudential supervision.

Additional Information
In responding to this inquiry the Society would like to draw attention to the following Royal Society of Edinburgh responses which are of relevance to this subject: Commercialisation Enquiry: Final Report (1996); The Innovation - Exploitation Barrier (January 1997); Engineering and Physical Sciences Based Innovation (March 1998); A New Strategy for the Scottish Enterprise Network (October 1998); Devolution and Science (April 1999); Developing Scotland’s Clusters (June 1999); .A Framework for Economic Development (March 2000); A Science Strategy for Scotland (July 2000); The Are We Realising Our Potential Inquiry (July 2000; January 2001); and Review of the supply of scientists and engineers (August 2001). 

Professor Peter Wilson CBE
General Secretary
Royal Society of Edinburgh
22-26 George Street
Edinburgh EH2 2PQ

October 2001

Further information is available from the Research Officer, Dr Marc Rands