As policymakers respond to the global recession, they should remember that the unprecedented global economic growth experienced in recent decades owes much to the removal of political and economic barriers to trade and investment. During that time, a division of labor on a truly global scale has emerged, presenting opportunities for specialization, collaboration, and exchange that affirm—and might even astonish—the great Adam Smith.

Falling trade and investment barriers, revolutions in communications and transportation, the opening of China to the West, the collapse of communism, and the disintegration of Cold War political barriers have spawned a highly integrated global economy with vast potential to produce greater wealth and higher living standards.

Today’s Factory Floor Spans the Globe

The dramatic reduction in transportation and communication costs, combined with widespread liberalization of trade, finance, and political barriers are all accomplices in what has been called “the death of distance.” Under the new paradigm, the factory floor is no longer contained within four walls and one roof.

Instead, the factory floor spans the globe through a continuum of production and supply chains, allowing lead firms to optimize investment and output decisions by matching production, assembly, and other functions to the locations best suited for those activities.

A Fresh Approach Is Required

These changes warrant a fresh approach to trade policy. In the 21st century, it is inaccurate to characterize international trade as a competition between “us” and “them.” Because of foreign direct investment, joint ventures, and other equity-sharing arrangements, quite often “we” are “they” and “they” are “we.” And as a result of the proliferation of disaggregated, transnational production and supply chains, “we” and “they” often collaborate in the same endeavor.

Under the new paradigm, workers in developed and emerging countries are more likely to be coworkers than competitors. Today’s global economic competition is less likely to feature “our” producers against “their” producers and more likely to feature entities that defy national identification because they are truly international in their operations, creating products and services from value-added activities in multiple countries. There is competition between supply chains, but success first demands cooperation and collaboration within supply chains (i.e., cooperation and collaboration between some of “us” and some of “them”).

This new commercial reality demands policies that are welcoming of imports and foreign investment, and minimize regulations or administrative frictions that are based on misconceptions about some vague or ill-defined “national interest.”

As Barriers Decline, Opportunities Rise

The driving force behind innovation and opportunity in this new era is the reduction and elimination of artificial barriers, both political and economic. As those barriers have diminished, opportunities for new combinations of labor, investment, and human capital have emerged in defiance of what were once formidable obstacles to wealth creation.

There have been signs in recent years that policymakers are beginning to grasp the new reality. “Autonomous” or “unilateral” liberalization of trade barriers has accounted for most of the trade liberalization in developing countries over the past two decades and, on average, applied tariff rates globally are well below their maximum allowable rates or “bound” rates under World Trade Organization agreements.

However, the financial crisis and subsequent global recession have tested the depth of that understanding and brought out the worst political instincts of some policymakers who think only about short-term political benefits and disregard longer-term costs.

Populist Reactions Are Damaging

In some cases, governments have raised trade barriers, subsidized domestic champions or imposed local lending or hiring requirements, all in the name of creating or protecting local jobs and supporting the local economy. Perhaps the most notorious protectionism during the current global recession has taken the form of restrictions on competition in government procurement markets.

Apparently, policymakers around the world still accept the pre-enlightened belief that proper stewardship of taxpayer resources and the optimal path to stimulating economies require limiting fiscal spending to products and services produced locally. It started with Buy American provisions in the United States, and like swine flu, has jumped borders to Canada, China, the Philippines, and Australia.

Requirements to lend and hire locally have also been imposed in some places. By indulging these reflexive, populist, once-considered-vanquished ideas, politicians have made matters worse, while reinforcing antiquated assumptions about how the global economy actually works.

Global economic integration has enabled enterprises to flourish on scales unimaginable just a generation ago. Not only should the reimposition of barriers under current economic conditions be eschewed, but a firm commitment to bring trade and investment policy up to speed with 21st century commercial reality would be a wise investment in the future.

To nurture the promise of our highly integrated global economy, governments should stop conflating the interests of certain producers with the national interest and commit to policies that reduce frictions throughout the supply chain—from product conception to consumption—as well as in the flow of services, investment, and human capital.

What Constitutes an American Car?

Economist Matthew Slaughter, in a recent Wall Street Journal op-ed, attempted to elucidate: "What exactly makes a car 'American'? Does it mean a car made by a U.S.-headquartered company? If so, then it is important to understand that any future success of the Big Three will depend a lot on their ability to make—and sell—cars outside the United States, not in it. A big reason Chrysler has fallen bankrupt is its narrow U.S. focus. It has not boosted revenues by penetrating fast-growing markets such as China, India and Eastern Europe. Nor has it lowered costs by restructuring to access talent and production beyond North America."

However, the angry reactions from American labor unions, their patrons in Congress, and rabble-rousing television and radio personalities to GM’s proposal to reduce costs by shifting more production to Mexico and China suggest that the above definition of an American car is not universally embraced.

For those who objected to GM’s plans, it is not the company’s bottom line that matters, but rather the company’s capacity to create U.S. jobs and stimulate U.S. economic activity. For these detractors, the need for GM to have a viable plan to become profitable so as to create U.S. jobs and stimulate U.S. economic activity somehow doesn’t factor into the equation. Instead, in zero-sum fashion, they see investment in foreign operations as antithetical to domestic job creation and economic growth.

Perhaps, then, they would find Slaughter’s alternative definition of an American car more acceptable: "Or is an 'American' car one made within U.S. borders? If so, then it is important to understand that America today has a robust automobile industry thanks to insourcing. In 2006, foreign-headquartered multinationals engaged in making and wholesaling motor vehicles and parts employed 402,800 Americans—at an average annual compensation of $63,538—20% above the national average. Amid the Big Three struggles of the past generation, insourcing companies like Toyota, Honda and Mercedes have greatly expanded automobile operations in the U.S. In fiscal year 2008, Toyota assembled 1.66 million motor vehicles in North America with production in seven U.S. states supported by research and development in three more."

But many Americans—including many of those who reject Slaughter’s first definition—have rejected this definition of an American car as well. Ironically, the people who are most inclined to oppose outsourcing and define it as “shipping jobs overseas” tend to be the same people who criticize “insourcing” for shipping profits or control of U.S.-based assets overseas.

Even though the top-10-selling models of cars and trucks in the United States in 2008 were all produced in the United States, by both Detroit-based and foreign nameplate producers, and even though foreign nameplate producers employ hundreds of thousands of American workers, pay local and national taxes, support local economies, reinvest part of their earnings in their U.S. operations, and invest in other local businesses, the fact that corporate headquarters are located in Tokyo or Stuttgart or Seoul seems to hold sway. Yet, as put in another recent "Wall Street Journal" article: "Once you put down the flags and shut off all the television ads with their Heartland, apple-pie America imagery, the truth of the car business is that it transcends national boundaries. A car or truck sold by a “Detroit” auto maker such as GM, Ford or Chrysler could be less American—as defined by the government’s standards for “domestic content”—than a car sold by Toyota, Honda or Nissan—all of which have substantial assembly and components operations in the U.S."

At best, there is grudging acceptance of the possibility that these insourcing companies are part of the American manufacturing landscape. But it is impossible to imagine that the U.S. government would have ever rescued Toyota or Honda if they had presented with financial conditions as dire as Chrysler’s and GM’s.

The automobile industry is one of many that transcend national boundaries and is only one example of why international competition can no longer be described as a contest between “our” producers and “their” producers. The same holds for most industries throughout the manufacturing sector.

The “us” versus “them” characterization of the global economy has never been quite right, but with today’s levels of cross-border investment and economic collaboration, such thinking is dangerously anachronistic.

Where Are Dell and Nokia Made?

Dell is a well-known American brand and Nokia a popular Finnish brand, but neither makes most of its components or assembles its products in the United States or Finland, respectively. Some components of products bearing the logos of these internationally recognized brands might be produced in the “home country.” But with much greater frequency nowadays, component production and assembly operations are performed in different locations across the global factory floor.

Consider the Chinese-born computer company, Lenovo. Its executive headquarters are located in Beijing, Singapore, and North Carolina. It operates research centers in China, Japan, and the United States. And its production and assembly operations occur in China, India, Mexico, and Poland.

To call Lenovo “Chinese” or Nokia “Finnish” or Dell “American” misses the broader point that these companies are truly global entities with facilities, employees, and stakes in dozens of countries. Whereas a generation ago a product bearing the logo of an American or Japanese or German company may have been comprised exclusively of domestic labor, materials and overhead, today that is much less likely to be the case.

Today, that product is more likely to reflect foreign value-added, regardless of location of the company’s headquarters or the country affiliated most closely with the brand. The distinction between what is and what isn’t American or Finnish or Chinese has been blurred by foreign direct investment, cross-ownership, equity tie-ins, and transnational supply chains. As Samuel Palmisano, IBM’s chief executive officer, put it, “State borders define less and less the boundaries of corporate thinking or practice.”

A 2008 World Trade Organization report explains the pattern this way: "Recent theories of fragmentation predict that a reduction in trade costs leads to greater fragmentation of production, with firms geographically spreading the different stages of their production process. When trade costs of intermediate inputs fall, different stages of the production process can take place in different places."

Trade in intermediate goods related to “fragmentation of production” or “vertical specialization” or “production sharing”—terms given to the inexorable expansion of the factory floor across borders and oceans in response to falling costs—has grown faster than trade in final goods during the past two decades. The same is true for services.

Economists generally rely on trade data, input-output tables, and firm-level surveys to study trends in these multinational production-sharing operations. Though the literature describes different measurement approaches—each with its own strengths and weaknesses—the consensus conclusion, regardless of measurement approach, is that the trend toward vertical specialization continues to grow among countries large and small and across the globe.

Where is an iPod Made?

The iPod, according to the inscription on the back of every model, is “Designed by Apple in California; Assembled in China.” The iPod provides the quintessential model of transnational production in the 21st century. The process between the design and final sale of an iPod involves collaboration and cooperation within a production supply chain that spans several countries, supporting jobs and economic activity in each.

A 2007 study published by the University of California–Irvine sought to determine “who captures value in a global innovation system” by disaggregating the components contained in an Apple iPod and determining the companies and countries involved in manufacturing a unit in China. The authors found that the components were produced in the United States, Japan, Singapore, Taiwan, Korea, and China by companies headquartered in the United States, Japan, Taiwan, and Korea. The total cost of producing the iPod (components plus labor) was estimated to be about $144.

Most of the profits on the constituent components accrue to Japanese companies, who produce the most important and most expensive parts. Two U.S. components producers and a few from other countries capture small shares of the value. But the lion’s share of value accrues to Apple since iPods retail for $299 and the cost of production is $144 (at the time the study was conducted). Some of the $155 per-unit mark-up goes toward compensating U.S. distributors, retailers, and marketers, while the rest is distributed to Apple shareholders or devoted to research and development, which supports engineering and design jobs higher up the value chain.

The capture of value in the iPod production chain is fairly typical for western brands. James Fallows characterizes this process of outsourcing as following the shape of a “Smiley Curve” that is plotted on a chart where the production process from start to finish is measured along the horizontal axis and the value of each stage of production is measured on the vertical axis.

About this production process, Fallows concludes: "The significance is that China’s activity is in the middle stages—manufacturing, plus some component supply and engineering design—but America’s is at the two ends, and those are where the money is. The smiley curve, which shows the profitability or value added at each stage, starts high for branding and product concept, swoops down for manufacturing, and rises again in the retail and servicing stages. The simple way to put this—that the real money is in brand name, plus retail—may sound obvious, but its implications are illuminating."

Rather than appreciate how this complementary process harnesses the benefits of our globalized division of labor, some begrudge iPods sales in the United States for adding to the bilateral trade deficit. But as the iPod study authors caution, “For every $300 iPod sold in the U.S., the politically volatile U.S. trade deficit with China increased by about $150 (the factory cost). Yet, the value added to the product through assembly in China is probably a few dollars at most.”

Should we really lament a trade deficit in iPods or any other products assembled abroad, particularly when those products comprise U.S. value-added and support high-paying U.S. jobs? One implication is that Chinese and American labor is complementary in this process. Without the division of labor, ideas hatched in American laboratories by high-skilled, high wage American engineers would be less likely to materialize into ubiquitous consumer products because they would be too expensive to make and sell for mass consumption.

Without the division of labor, fewer ideas would go far beyond conception. As a consequence, higher paying jobs at both ends of the smiley curve would be more difficult to support, as would the lower value-added manufacturing and assembly jobs in China.

The U.S. economy may reap the most absolute value out of this arrangement, but from China’s perspective there are considerable benefits as well. U.S. technology and investment provide jobs that would not exist in China if this vertical specialization were not possible. The arrangement also provides a conduit for technology transfer and skills acquisition that helps raise Chinese productivity levels and standards of living.

China is in no way consigned indefinitely to performing low-wage, low-skill functions in the global supply chain. In fact, Chinese workers have been moving up the skills and value chain to perform more sophisticated tasks in globally integrated production networks, yielding lower-skilled functions to workers in Vietnam and other poorer countries.

The dismantling of global barriers, both political and economic, is a hallmark of the progress achieved in the second half of the 20th century. The economic growth it unleashed is indisputable.

Today, increasing numbers of people in a diversity of countries depend on this openness. Their livelihoods demand access to imported materials, components, equipment, and foreign investment.

Trade Statistics Are Misleading

The proliferation of transnational supply chains renders trade statistics—import value, export value, the trade balance—rather misleading, if not meaningless. What significance should be attached to the fact that the United States runs a trade deficit with China when Chinese value-added accounts for only about 50 percent of the value of U.S. imports from China?

The other half is value-added from other countries. As concluded in a recent OECD study:

Exports of final goods are no longer an appropriate indicator of the (international) competitiveness of countries, as following the emergence of global value chains, final goods increasingly include a large proportion of intermediate goods that have been imported into the country.

The new interdependence and the global division of labor are described in a recent report from the U.S. Congressional Research Service:

Trade policy aimed at curbing imports from China, for example, would likely affect Chinese exporters and ancillary sectors, but it also may hit subsidiaries of U.S. companies and manufacturers whose supply chains stretch there. It is not surprising, therefore, that some of the strongest voices both for and against trade protectionism come from American-based manufacturers and service providers.

The New Order

International trade today is no longer a competition between our producers and their producers. It is more appropriately characterized as a competition between entities that increasingly defy national identification. Dramatic increases in cross-border investment and the proliferation of transnational production and supply chains have blurred any meaningful distinctions between our producers and their producers.

Understanding this new reality and the process that spawned it must become second nature to policymakers and the public if we are to vanquish, once and for all, the outdated, zero-sum-game characterization upon which rests the argument for protection and insularity.

About The Author Daniel Ikenson [Full Bio]

Dan Ikenson is an author, speaker and Director of The Cato Institute’s Herbert A. Stiefel Center for Trade Policy Studies, focusing on WTO disputes, regional trade agreements, U.S.-China trade issues, steel and textile trade policies, and antidumping reform.