101ThingsEveryoneNeedstoKnowabouttheGLOBALECONOMYTheGuidetoUnderstandingInternationalFinance,WorldMarkets,andHowTheyCanAffectYourFinancialFuture

MichaelTaillard,PhD

DEDICATION

This book is dedicated tomy children, Dante, Gabriel, Katherine, andAmelia. It is my hope that this book will help people to make betterdecisionsthanthosebeingmadetoday.

Contents

Introduction

Chapter1:TheBasics

1.Globalization2.ProductionPossibilitiesCurve3.AbsoluteAdvantage4.ComparativeAdvantage5.GainsfromTrade6.TermsofTrade7.VarietyVersusRegionalization8.EconomiesofScale9.EconomiesofAgglomeration10.Localization

Chapter2:OrganizationsofGlobalEconomics

11.WorldTradeOrganization12.WorldBank13.InternationalMonetaryFund14.OrganisationforEconomicCo-operationandDevelopment15.OrganizationofPetroleumExportingCountries16.Governments17.NongovernmentalOrganizations18.MultinationalCompanies19.G8Summit

Chapter3.BalanceofPayments

20.CurrentAccount21.CapitalAccount22.TransferPayments23.TradeImbalance24.FactorPriceEqualization25.Mercantilism

Chapter4.Currency

26.FixedExchangeRates27.DevaluationandRevaluation28.FloatingExchangeRates29.DepreciationandAppreciation30.PurchasingPowerParity31.InterestRates32.InflationRates33.InternationalFisherEffect34.Marshall-LernerCondition35.OtherExchangeRateDeterminants36.TheGoldStandard37.SpecialDrawingRights38.ForeignExchangeReserves

Chapter5.RestrictionsonTrade

39.Tariffs40.Quotas41.SubsidiesandDumping42.Embargoes43.Volatility

44.CounterfeitingandIPViolations45.Infrastructure46.EnvironmentalandConsumerProtectionRegulations47.TradeWar

Chapter6.ManagingGlobalRisk

48.TransactionRisk49.PoliticalRisk50.InterestRateRiskandInflationaryRisk51.TranslationRisk52.LegalRisk53.ConvertibilityRisk54.Risk-FreeAssets55.Insurance56.Futures57.Forwards58.Options59.foreignexchangeSwaps60.Barters

Chapter7.ForeignInvestment

61.ForeignDirectInvestment62.ImportsandExports63.PartnershipsandJointVentures64.MergersandAcquisitions65.WhollyForeignOwnedEnterprise66.FinancialInvestment67.InternationalDiversification68.Eurobonds69.SourcingCapitalGlobally

70.InternationalPortfolioOptimization71.GlobalCostofCapital

Chapter8.MovementofCapital

72.TradeGravity73.Industrialization74.Urbanization75.UrbanSprawlandDecay76.InternationalMigration77.Westernization78.CapitalFlight79.BrainDrain80.TaxManagement81.TransferPricing82.InternationalLogistics83.IncotermsChapter9.Integration84.FreeTradeZones85.PreferentialTradeArea86.FreeTradeArea87.CustomsUnion88.CommonMarket89.EconomicUnion90.MonetaryUnion91.InvoluntaryIntegration92.EuropeanUnion

Chapter10.Development

93.Growth94.Development

95.IncomeDisparity96.DevelopedandDevelopingNations97.Least-DevelopedNations98.TheNorth-SouthGap99.SourcesofDevelopment100.UrbanRenewal101.InfluenceofMultinationalEnterprises

INTRODUCTION

Think back to the last time you bought a car. Of course, you wereinterestedinquestionslike,Whatkindofmileagedoesitget?What’sitssafety record? And does it come in a really cool shade of red with abitchin’CDplayer?Butyoualsomighthavewonderedif itwasbuilt inAmerica.Was it

from the assembly lines of the Big Three—General Motors, Ford, orChrysler? Was it the product of American workers, or were youcontributing in some small way to shipping those manufacturing jobsoverseas?Thesedays,moreandmorepeopleask themselvesquestions suchas

these. But the reality is that the vehicle you drive, regardless ofwhatcompany’sname ison it, is composedof thepartsand laborsofmanynations. It was, perhaps, assembled in Mexico, with parts from ChinaandelectronicsfromTaiwan,fashionedfromnaturalresourcesextractedfromSouthAfrica,usingengineeringspecifications fromGermany,andfueledwithoilfromSaudiArabia.Intruth,almostnothingthat’sapartof our lives comes from only one country. These things are allinterconnected in complex ways, and each international connectioninfluences a range of things, from the amount ofmoney youmake atworktowhereyoulive.CallittheEconomicButterflyEffect.ThepriceofriceinChinareallydoesinfluenceyourcreditcard’sinterestrates,butifyoudon’tknowwhy,there’slittleyoucandotoprepare.Global economics studies those relationships between people of

different geographic locations as they participate in economictransactions. The dynamics of the economic relationships betweennations,orevenbetweendifferentpartsofasinglenation,presentrisksandbenefits toyou.Thebetteryouunderstand theserelationships, themore successfully you’ll be able to adapt to the changes that areoccurringdailyinyourlife:everythingfromgaspricestoyourcustomer

serviceexperienceatadepartmentstore.Themechanismsbywhichtheseeconomictransactionstakeplaceandinfluence other transactions are varied, but they occur at everygeographicandeconomic level.Youmightwant to “BuyAmerican” inthe hope of saving American jobs and contributing to our nationalprosperity.Butintruth,youmightaswelltrytonarrowyourselfdownto purchasing all your goods at a single store. It won’t do you muchgood.Notonly is it justabout impossible,buteven ifyoucoulddo it,thestoreownerdoesn’twanttosellexclusivelytoyouandnooneelse.Forbetterorworse,todayweliveinaglobalsociety.Theworldwon’tdisappear justbecauseyoucloseyoureyes. Instead,globalismpresentsus with a world of opportunities if we can see them. As Americansexpandourrangeofpossible transactionpartners, thepotentialbenefitforeveryoneincreases.The risks associated with globalism don’t lie in trading with othercountriesandinbuyinggoodsthataremadeelsewhere.Rather,they’rein being unprepared for what the world has available. When youunderstandhowpeoplebehaveintheirattemptstomakethebestuseoftheplanet’sscarceresources,you’llhaveagreaterunderstandingofhowtheglobalcommunityaffectsyourlifeandwhatyoucandotoadapttoanever-changingworld.

CHAPTER1TheBasics

Issuesinglobaleconomicsarecommonnewsstories,butit’ssometimesdifficult to find outwhat any of it actuallymeans. Even though thosecurrent events are among themost important in your life, the peoplewhogiveyouthenewsoftendon’tknoworexplainhowtheseissueswillaffectyou.Thisiswhyweshouldstartwiththebasics.Notonlyiseverythingelse

inglobaleconomicsbuiltuponthesefundamentals,buteventhesemostbasic principles impact our daily lives. Unless you know what you’relookingfororhowtoproperlyrespond,you’reatthemercyoftheebbandflowoftheeconomictidesthatreachacrosstheglobe.

1.GLOBALIZATION

Globalization refers to both the increasing integration of the world’snations and the process by which that integration occurs. Althoughglobalizationisnotanewconcept—therearemajor internationaltraderoutesdatingbackat leastas faras2,000B.C.—trends in technologicaladvancements and cross-border issues have dramatically increased thedegree to which far-separated locations on the earth have becomeinterconnected, both economically and otherwise. Much of whatcontributestotheincreasedglobalizationisattributed,rightfullyornot,totheeffortsofgovernmentsastheyworktocoordinateagreementsandtreaties that facilitate these international interactions (thedevelopmentof trade blocs such as the European Union, for example). The reality,however, is that globalization often occurs independent of anygovernmentpolicy.

Increasing globalization is inevitable; it affects all industries and allnations. What is its real cause? In a word: technology. As we makeimprovements in our ability to communicate instantly across longdistances andmore quickly transport people and cargo, our ability totake advantage of the benefits of associating with foreign nationsincreases.Notonlyhavethesetechnologicaladvancesmadeitfasterandmore convenient to buy and sell goods across the globe, but it’s alsocheaperbecausewe’re improving the cost efficiencyof communicationand transportation, as well as decreasing the risks associated withtransportinggoodsoverlongdistances.Considersuchnewtechnologyasthecargojet,thecomputer,orevenjustthetelephone.Becauseoftheseinventions,toplaceanorderwenolongerhavetosendaletteroverseas(whereitcaneasilygoastray).Wedon’thavetopayahigherpricetocovertheriskthatthecompanywe’rebuyingfrommightloseshipmentstostormsorbandits.Globalizationisafact,butlikemanyfacts,itisn’tallgoodorallbad.Forexample,pollutioncrossesnationalboundarieswithoutconcern forwhat policies are in place to limit international trade. The airbornecarbonfromaChinesecoalpowerplantisdispersedthroughtheglobalatmosphere just as easily as the ash from an Icelandic volcano or thefallout from a nuclear bomb. At the same time, research and trade ininformationgoesondailybetweennationsusing informalorunofficialchannels.Globalizationmeanswecanbettertakeadvantageofagreaterrangeof markets to which we can sell our goods or from which we canpurchase our supplies. Economists study and try to explain humanbehavior in their relations with one another. Globalization is aninevitable result of our own attempts to maximize the value of ourtransactions.Ithasincreasedduringthepastfewdecadesasaresultoftechnologicaladvances,andsohasglobaleconomicinterdependence.

WhatYouShouldKnowIf youbuy something fromsomeoneon theother sideof theplanet,the principles are still the same as if you were trading with someoneacross the street. National boundaries are artificial barriers that addcomplexity to our transactions (which will be discussed in later

chapters), but other than the sheer distance involved, the transactionsthemselvesarenodifferent.Let’s pretend for amoment that you live in the 1700s. The primarymodes of transportation are horse and boat, and the best method ofcommunicatingacrosslongdistancesistoshout—really,reallyloudly—orsendahandwrittenletter.Topurchasesomethingfromtheothersideoftheworldisanuisanceandtakesalongtime.Fast-forward to the twenty-first century. It isnoweasier topurchasethings from halfway around the globe than it was to purchase thingsfromacrossasinglenationintheeighteenthcentury,thanksprimarilytoour technological advances. Today, rather than sending a courier ormerchantonajourneylastingmanyweeksormonthstoretrievegoodsand bring them back (all the while carrying valuable money ormerchandisethatisliabletobedamagedorstolenalongtheway),youmakeaphonecallorvisitawebsite.Withinaweektheitemisdeliveredtoyourdoorstep.Peoplenowhaveaccesstoawidervarietyofgoods,atvarying levels of quality and price, which are not always availablewithintheirownnation.A single look in your spice cabinet tells the entire story. Threehundredyearsago,yourcollectionofspices—whichinthiscenturyyoumost likely bought in the same store for just a few dollars each—requiredcaravanstotravelfromChinaallthewaytoGreecebyhorseorfootalong thedifficultpathknownas theSilkRoad.The tradewas soprofitable that despite the cost of sustaining a team of people formonths,entireempireswerebuiltonthesaleofgoodsconsideredtoberareorexotic(suchasspices).Inthemodernera,exposuretoandintegrationwithotherculturesisanormal part of everyday life. There are probably a handful of ethnicrestaurantsorstoreswithinashortdrivefromwhereyoulive.Theaislesof your local supermarket display tea from China, marmalade fromScotland,matzoh from Israel, and naan and poori from India. Foreigntrade has become more about cost efficiency than the availability ofexotic goods. (In fact, most of these foreign goods are no longerconsideredespeciallyexotic.)Despite technologicaladvances,however,governments are no more successful at truly prohibiting or evenrestricting foreign trade without self-harm than they were in the

eighteenthcentury.Thinkaboutitthisway:ImagineyouliveinMetropolis,whichisafew

milesawayfromGothamCity.Metropoliswantstodiscourageyoufromshopping in Gotham and keep you—and your money—in Metropolis.Thecitydecides toputa taxonanygoodsyoupurchase fromGothamCity. However, as long as prices in Gotham are still lower, even afterpayingthetaxtoMetropolis,you’llstillshopthere,won’tyou?EvenifMetropolisraisedthetaxsohighthatyoudecidedtoshopin

your own city, would you benefit by paying higher prices? No. Thepeople of Metropolis would just be paying more for their goods thannecessary. Businesses that would normally buy their supplies fromGothamCityarepayingmorefor thosegoods,resulting inevenhigherprices.In an effort to retaliate, Gotham City now institutes its own set of

taxes.Andnowit’simpossibleforMetropolistosellitsowngoodstothecitynextdoor.Metropolis,uppingthestakesinthetradewar,institutesalawthatprohibitsyoufromshoppinginanyothercity.Doesthathelpthe businesses in your city? Of course not, because now Metropolisbusinesses are uncompetitive. The people of Gotham City never wentaway;youjuststoppedbeingabletobuyfromandselltothem.Instead,you have to rely on just one city from which you must purchaseeverythingyouneed.Costsgoup,availabilitygoesdown,andeveryoneisharmedintheprocess.

WhyYouShouldCareMany people think that globalization is something created by the

government, that globalization is taking away jobs. Theywant to stopthe current trends inglobalization.But aswe’ve just seen, even if youclose your borders entirely, the world is still out there, with all itsterrifyingthreatsandgloriousopportunities.Thebestthingyoucandototakeadvantageoftheopportunitiesandmitigatetherisksistosimplybeawareofwhat’sgoingonaroundyou;expandyourattentiongloballyratherthanonyourimmediategeographicsurroundings.No matter what the circumstances, in today’s world information is

king. As noted, the increased trend in globalization is a result ofimprovedtechnologicaladvances,sousethoseadvancestoincreaseyour

advantages.TheInternetisprobablythebesttoolavailableforpriceandavailability comparisons, as well asmanaging shipping and payments.There are a wide variety of companies online designed specifically tofacilitatesuchtransactions.

2.PRODUCTIONPOSSIBILITIESCURVE

Theproductionpossibilitiescurveisagraphthatglobaleconomistsuseintheirstudies.Itillustratesthepotentialcombinationsofthetypesandquantitiesofgoodsthatanationiscapableofproducing.Thisisreallyprettysimple.Atagivenpoint,anynationcanproduceacertain amount of various types of goods in different combinations.When a nation is producing the maximum quantity of goods possible(thatis,thenationisusingallitsproductionpotential),thisiscalledtheproduction possibilities frontier because the nation can produce noadditionaloutput.Ifanationisproducingthemaximumamountofanyparticulargoodorservice forwhich ithas theavailable resources, inorder toproducemore it must give up resources from something else. (This is calledPareto Efficiency.) Naturally, any nation can produce less than themaximumofwhich it’s capable, but, for tradepurposes,nations try toavoid such inefficiencies (this is discussed further in topic 4,ComparativeAdvantage).Forsimplicity,globaleconomistsoftendiscusstheproductionpotentialcurveusingonly twodifferent typesofgoods.Of course,nationsproducemore than just two typesofgoods,but thepremiseremainsthesame,nomatterhowmanydifferentkindsofgoodsareinvolved.

WhatYouShouldKnowThe bad news is that every nation, regardless of size, has limitedproduction potential; it can produce only a limited amount of anyspecific type of product or service. The good news is that each nationtendstoexcelintheproductionofafewdifferenttypesofproductsandservices.Theotherpieceofgoodnews is thateven ifyournation isn’tespecially good at producing something, there are other nations that

excelatproducingthosegoodsandservices.Whenanationmustgiveupsome part of the production of one good in order to producemore ofanother,thisiscalledtheopportunitycost.Let’ssaytheonlytwothingsyournationproducesarebeerandpizza.

You’re able toproduceamaximumof$100,000ofbeer, but thenyouhave no resources to produce any pizza at all. You’re also able toproduce$50,000ofpizzas,butthenyou’dhavenoresourcestoproduceanybeer.Onaverage,you’dhavetogiveuptwogallonsofbeerjusttoproduceoneadditionalpizza,whileyou’donlyhavetogiveuponepizzatomaketwoadditionalgallonsofbeer.Thatmeansyou’reusing fewerresourcesforeverygallonofbeerproducedthaneverypizzaproduced.Okaysofar?Anotherwayof lookingat it is thatyoucanproduce twiceasmuch

value in beer than pizza using an equal amount of resources. Theopportunity cost of producing $100,000 in beer would be $50,000 inpizza.That’swhatyou’dbegivingupinpizzatoproducethemaximumamountpossibleofbeer.Each nation has its own production possibilities curve. National

growthcanoccureitherwhenanationproducesatalevelclosertoitsproduction possibilities frontier—in other words, it gets rid ofinefficiencies—orwhenitexpandsitsproductionpossibilitiesfrontier.Ineithercase, thenation isproducingmore than itwasbefore. Increasedeconomicefficiencyoccurswhenanation:

Producesmore,usinganequalamountofresources

Producesanequivalentamount,usingfewerresources

Producesmore,usingfewerresources

Thisdoesn’tchange theproductionpossibilitiescurvedirectly,but itchanges the quantity of different goods being produced to maximizeresourceusage.

WhyYouShouldCareThetradeoffinherentintheproductionpossibilitiescurveofanation

determines theprices that anationpays for its goods relative toother

nations. Ifyouhave tousemoreresources toproduceagood than thenext nation over, the price you’ll charge for that good will be higherbecausethecosttoproduceitishigher.This is true of all transactions, not just international ones. Let’s say

you’reafarmerwho’sverygoodatgrowingcorn,butittakesyouaverylong time tomake farm tools. Your neighbor is good at making farmtoolsbutnotsogreatatgrowingcorn.You’llendupsellingyour farmtools forahigherprice thanyourneighborbecause it takesmore timeandeffort.Ontheotherhand,ifyoubuyfarmtoolsfromyourneighborusing the corn you grew (or at least themoney you earn from sellingcorn), then you’ll be better off. This is why we buy and sell stuff.Otherwise,we’dalljustmakeeverythingourselves.The total size of a nation’s production possibilities curve plays a

criticalroleindeterminingwhichnationsarelarge,rich,andpowerful.Inotherwords,theproductionpossibilitiescurveofthenationyouliveinhasbeenalargefactorinyourqualityoflife.Essentially,thenationsthat improvedover the centurieswere those thatwereable toharnessthe production potential of the natural resources available to them.These include high-yield, nutrient-dense foods that can be farmed sopeople have time to develop other skills, animals that can bedomesticated so people can use their resources, and natural mineralsfromwhichtoolsandinfrastructurecanbebuilt.

3.ABSOLUTEADVANTAGE

A nation with an absolute advantage in a particular good is able toproduce more of those goods using the same or a smaller amount ofresourcesassomeothernation.Often,havingalotofnaturalresourcessuchasarableland,minedgoods,oil,gas,orothersuchthingsisenoughtogiveacountryanabsoluteadvantage.Aslongasthevolumeofthesethingsexceedstheamountthatisconsumeddomestically,thenationcanselloffthesurplus.For instance, if Nation A can use 100 pounds of wheat to produce

1,000 bottles of beer and Nation B can use 100 pounds of wheat to

produce5,000bottlesofbeer,NationBhasanabsoluteadvantageoverNationAinbeerproduction.ThereasonsforthismaybethatNationBhasamoreefficientproductionprocessthanNationAandknowshowtoderivemorebeerperpoundofwheat.It’salsopossiblethatlaborcostsinNationBarelowersoitcostslesstoproduceabottleofbeerthere.

WhatYouShouldKnowHavinganabsoluteadvantageinonegoodorserviceisn’tashelpfulintrade as you might think. Those nations that don’t have an absoluteadvantageinaproductwillnotexportitbecausesomeothernationcanproduce the goodmore cheaply. Nation B in our example abovemayexport some of its beer, but this won’t last for long. As demand forNation B beer grows, so will its price increase, including labor costs.OvertimethisdiminishesNationB’sabsoluteadvantage,andeventuallysomeothernationwillbeabletoproducebeerjustascheaplyasNationB.

WhyYouShouldCareRelying on absolute advantage for a nation’s economic health isextremely inefficient. As we saw above, absolute advantage in anyproductisatemporaryconditionthatiseventuallyerodedbytrade.Soyou shouldn’t get too complacent, even if right now your country canproduce more beer more cheaply than anywhere else. Given freeinternational trade and growing demand, it won’t be that long beforeyour six-packsare rising inpriceandmoreandmorebeers fromothercountriesareshowingupinyourlocalsupermarket.

4.COMPARATIVEADVANTAGE

A nation has a comparative advantage over another nation in theproductionofsomegoodorservicewhenithaslessopportunitycost.Inother words, the nation has to give up fewer resources for theproductionofothergoods inorder toproduce something thananothernationdoes.Thisnotonlyincreasesefficiencyinresourceusage,therebydecreasingthecostsfortheproductionofthatitem,butitalsomakesthe

economyasawholemoreefficientinitsallocationofresources.

WhatYouShouldKnowComparative advantage is the primary basis for all sustainableinternational trade, and the basis for all transactions that take placewithin a single nation. Imagine for a moment trying to produceeverything you need to survive. You have to build your own shelter,groworhuntyourownfood,andsoon.Alternatively,youcanfocusonmakingextraofwhateveryou’reabletoproducethemostof,usingtheresources available to you and trading that surplus for everything elseyouneed.When individuals focusondevelopingan expertise in just afew skills and doing those very well, it’s called specialization or thedivision of labor.When this happens on a global scale, where all thecompaniesofanationfocusonperformingthosefunctionstheycandowell using as few resources as possible (meaning cheaply), then it’scalled operating within their comparative advantage. Even if a nationdoesn’t have an absolute advantage in anything, nations benefit bytakingadvantageofeachother’scomparativeadvantage.Comparative advantage differs from absolute advantage in that it ismore concerned with opportunity cost than financial cost. As we sawabove, an absolute advantage tends to be a temporary state of things.Havinga comparativeadvantagemeans that thenation is specializing,usingitsresourcesmoreefficiently,keepingcostsdown,andrelyingonothernationstoproducethosethingsthat itmaynotbeaseffectiveatmakingitself.

WhyYouShouldCareSometimespeopleforgetthattheseissuesinglobaleconomicsarejusta composite ofwhat the people and companies of a nation are doing.Comparative advantage is one of those issues. When a company is“sendingjobsoverseas,”whatthatactuallymeansisthatsomethingthecompany used to do is a function in which your nation has acomparative disadvantage. It’s now cheaper for the company tooutsourcethatfunctiontoanothernation.Complaining about this or appealing for government protection isn’tgoing to help anyone. If a country’s competitiveness is sustained only

through lawsuits and economic protection, then its increased resourceuse is harming the ability of other people and other companies to becompetitive in the global market. This throws the entire nationaleconomyoutofequilibrium.Many individuals and companies adapt to this problem of having a

comparativedisadvantage.Someinnovate, introducingnewmethodsortechnologies that reduce costs, improve quality, or alter the productmarket.Otherswillalter theirpositionwithin themarket:perhaps theybecome importers rather than producers, or focus their operations toperformonlyonefunctionoftheproductionprocess.Whatever you do for a living, remember this: There’s probably

someonesomewhere in theworldworkingonabetter,cheaperwaytodoitandsogainingcompetitiveadvantage.

5.GAINSFROMTRADE

Gainsfromtradeoccurwhentwonationsexchangethosegoodseachiscapable of producing cheaply; together they produce more than eachcouldeverhopetoproduceontheirown.Thisispossiblewhennationsrelyontheirrelativecomparativeadvantages.Eachoneproducessurplusamounts of those things that can bemade using fewer resources. Thecountriesthensellthesesurplusestoeachother.Asaresultofthisglobaltrade,everynationhasmoreresourcesavailabletoit.

WhatYouShouldKnowGains from trade are only possible when the people of each nation

focus on producing those things in which they have a comparativeadvantage while importing goods from another nation that holds acomparative advantage over them. Hark back to the beer and pizzaexampleweusedearlier.Inthiscase,itcoststwobeerstoproduceonepizza. Conversely, it costs one pizza to produce two beers. Now let’simagine that this production is split between two nations. Here is theproductionofeachbeforetrade:

NationA:$10,000beerand$5,000pizza

NationB:$2,000beerand$4,000pizza

NotethatNationAhasanabsoluteadvantageinbothbeerandpizza(thatistosay,itproducesmoreofboththandoesNationB)butNationBhas a comparative advantage in pizza.Without trade, themaximumtheycouldproducetogetheris$21,000ingoods.Eachcountryisbetteratproducingdifferent things. If eachonedecides to specialize inwhatit’sgoodat,allocatingresourcesfromitsweakerindustrytoitsstrongeroneandthentradingitssurplus,wecanendupwithgainsinthetotalnumberofgoods:

NationA:$20,000beerand$0pizza

NationB:$0beerand$8,000pizza

Nowthe twonationsareproducing$28,000 in totalvalue.Sowheneach nation produces only what each is very good at rather thanattempting to produce everything, even if one nation has an absoluteadvantageineverything,theybothbenefit.Eachofthemdecreasesitsownuse of national resources, whichmeans lower costs,more competitivebusiness,andmoresustainablegrowth.

WhyYouShouldCareTradeinthismannerincreasestotalwealthforeveryonebecausethere

isamuchlargertotalvalueofresourcesineachnationcomparedtothenumber of people. That’s great news when you’re talking aboutincreasing national wealth or even creating a sustainable economy.Thosenationsthatparticipateintradeincreaseinwealthmorequickly,and a proportion of thatwealth translates into a better quality of lifewithinthenation.

6.TERMSOFTRADE

One way to measure the value of trade between nations is with acalculation called the terms of trade. The terms of trade compares thevalueofanation’sexportswith its imports,expressedasapercentage.

Therearetwoversionsofthiscalculation:thetwo-nationmodelandthemultiple-nationmodel.Thetwo-nationmodelissimplerandiscommonlyusedtoexplainhow

the terms of trade calculation works. It also provides additionalinformation when assessing things such as the balance of payments,exchangerate,andrelativebusinesscycle fluctuationsbetweennations(discussed in later chapters).Tomake this calculation,divide the totaldollarvalueofanation’sexportsbythetotaldollarvalueofitsimports,andthenmultiplytheanswerby100.Thisratiomeasuresthevalueofanation’simportsandexports.So,if

Brungariaexports$1,000worthofgoodstoFreedoniaandimports$500worth of goods from Freedonia, then Brungaria has exports worth 50percent more than Freedonia and Freedonia has imports worth 200percentofthoseofBrungaria.Ifyou’rethinkingthatitreallycan’tbethatsimple,sadly,you’reright.

This calculation is only a starting point for figuring out the value oftradebetweennations.The realityofanation’s termsof trade ismorecomplex since trade typically occurs betweenmultiple nations, tradingmultiple goods,with different advantages and currency values. This iswherethemultiple-nationmodelfortermsoftradebecomesimportant.Themultiple-nationmodelisactuallyoneofseveralprice-indexmodelsfor trade that can account for a wider variety of import and exporttransactions. In a realistic scenario, these become very involved. Butdon’tworry—I’mnotgoingtooverwhelmyouwithalotofmath.

WhatYouShouldKnowAnation’stermsoftradeisnotameasureofitseconomichealthorthe

competitivenessof itsproducts intheglobalmarket. Instead, thetermsof trademerelymeasures a ratio of total value of imports to exports.This ratio is meaningless without context. What you need to know ishowyoushouldinterpretthevaluebasedonthegreatercontextoftradebalanceandvariationsofeconomiccyclesbetweennations.Anytimethetermsoftradeseemstocontradictothertrendingfactors

for these areas of economic concern, you can reasonably assume thatsomethingelseiscausingtherelationship.Alongthesamelines,ifsometradeissueappearstobeinexplicable,measuringthetermsoftradecan

helppointyouinthecorrectdirection.Usingthetermsoftradeasasingleindicatorislikenoticingasingle

landmarkwhileyou’reonalongjourney—itcantellyouwhetheryou’reontherightpath,butitwon’treplaceapropermapandcompass.

WhyYouShouldCareOrganizations, individuals, and even entire nations use the terms of

tradetopredictfluctuationsintrade,exchangerates,andeconomicwellbeing.Ifyourcountryhasextremelyhightermsoftradebutaparticularcompany in which you’re interested (for example, for investingpurposes)isexportinglittle,itmayindicatethatthecompany’sindustryhas a poor comparative advantage globally. Knowing what to expectfrom trade will guide decisions about how best to take advantage offoreignopportunities.

7.VARIETYVERSUSREGIONALIZATION

People like variety—but not too much. Consider some “ethnic”restaurantchains.TacoBellisn’treallyMexicanfood,theChineseBuffetisn’treallyChinesefood,andallthefastfoodrestaurantsyoucanthinkofthathavebranchesinChinaareservingitemsthatcatertothelocaltastesandpreferencesratherthanthoseitemsthatoriginallymadethemfamous in this country. That’swhere the tradeoff between variety andregionalization lies—in people’s desire for something different but nottoodifferent.Ineconomics,varietyistypicallyconsideredtobeagoodthing,since

diverseproductofferingsprovideconsumerswithdifferentoptionsthatappeal to many tastes while stimulating competitive innovation. Thereputation in the United States of Swiss clocks, Chinese silk, Indianspices,andItalianclothingstemsfromthefactthatdifferentregionsareable to offer better-quality products than are available domestically.People throughout theageshavedesired the foreign, thenew,and theexotic. Inordertogainsomenewexperience,welooktoothernations…onlytofindout,quiteoften,thatitisn’ttoourliking.

WhatYouShouldKnowThereisaninformalslidingscaleforglobalproducts.Ononeextreme

arethosethingsthatarecompletelyfamiliartous;ontheotherarethosethat are completely unfamiliar.Anyone involved in foreign trademustfindabalancethatoptimizespersonalbenefitandcompanysales.Ifthecompany’s products are too unfamiliar, violate too many taboos, orcontrastwithestablishedtastestoogreatly,notenoughpeoplewillbuythe product for the company to be competitive. If the company’sproductsaretoofamiliar,thereislittletodifferentiatethemfromthoseproduced by domestic companies. The goal, then, is to differentiatethroughtheirofferingswithoutalienatingtheircustomers.Goods and services that are in stark contrast with cultural norms,

while enticing for a small percentage of customers, typically will notcompete well. For example, in the United States, Chinese restaurantshaveaverydifficult timeselling traditionalChinese food(e.g.,braisedchicken feet) to people from a non-Chinese background. Instead, theysell such things as General Tso’s Chicken (which, by the way, isn’tChinese at all) because it uses flavors and ingredients that AmericanconsumersassociatewithChinesecooking.

WhyYouShouldCareIfyou’reasmallbusinessowner,youmaybeseeking toexportyour

goods, so it’s important to understand the market you hope will bepurchasingthem.Isyourproductonethathasvariabletraits?Evenifallyou do is grow rice, there aremultiple types of rice, each varying inpopularityandpricebasedon the individualnation.Maybe thenationyou’re considering exporting to tends to prefer long-grain rice, whileyourcompanyhasproducedonlyjasminericeuntilnow.Thatbringsustothenextquestion:Doesyourproductlineoffertraits

thatthepotentialcustomermarketwillwant?Youmightbeabletosellyourjasminericeasatypeofhigh-endforeigndelicacyrice,but if thepeopleofthatnationhavenorecipesthatusethistypeofrice,theystillwon’tbeinterestedunlessyoucanmarkettherecipesjustaseffectivelyasyoumarkettherice.Youneedtobeawareofwhetherornotyou’reapplyingassumptionsofyourownnationtopeoplefromothernations.As an informed consumer, you need to understand the impact

regionalization has on products and whether it will influence theproduct you are purchasing. Your expectations about the productmaydiffersignificantly fromthoseofconsumers in theproduct’scountryoforigin. For years,Westerners assumed Chinese-made products were ofpoor quality. The reality is that the expectations for cheapmanufacturingweredifferentinChinathantheywereinmanyWesternnations. China had experienced decades of economic mismanagement,whichforceditsmanufacturingmethodsbacktoanearlypre–IndustrialRevolutionera.This,incombinationwithpressureputonmanufacturerstomaintainminuscule profitmargins, caused a high degree of qualityproblems, including someunsafegoods.The situation couldhavebeenavoidedhadthecompaniesperformedtheirduediligencetoensurethattheproductswerebeingmadetotheexpectationsoftheirtargetmarketratherthantheexpectationsoftheChinesemarket.

8.ECONOMIESOFSCALE

When a company can produce something more cheaply per unit byincreasingquantities,wesayit’screatingeconomiesofscale.Thinkofitlikeabulkdiscount,butonamuchlargerscale:whenacompanysellsmoreofaproduct it’sabletochargea lowerpricefor it.Thishappensfortwoprimaryreasons:

1. Increasedefficiencyintheusageofavailableresources(internaleconomiesofscale)

2. Lowerper-unitcostofsupplieswhenpurchasedinlargevolume(externaleconomiesofscale)

Internaleconomiesofscalemeanacompanyismoreefficientlyusingits assets. Let’s say a company owns one factory and one machine toproduce itsproducts.Themachineproduces250unitspermonth.Thecompanyimprovesitsmachinetothepointthatitcannowproduceupto500unitsoftheproduct.However,thecostofmaintainingthefactoryeach month hasn’t changed; the only increase in cost has been thesuppliesputintothemachinetomaketheproducts.So,ifthecompany

increasesthenumberofproductsitsmachineismaking,theaveragecostper product for the company decreases since the company is nowmakingmoreproductswithoutchangingthemonthlycostofthefactory.Lookatitthisway:

Ifthecompanybuysalargermachine,abletoproduce1,000units,itcan reduce its costs even more. Of course, if the company only hasenoughwarehouseroomtostore500units,thenit’spayingforalargermachine but can still only produce a maximum of 500 units. At thispoint, the ability to produce more units increases the average cost,causingdiseconomiesofscale.Externaleconomiesofscaleoccurwhenacompanyisabletopurchasesupplies in large volumes. If a company grows so large that it needsmore supplies than other companies can provide without increasingproductioncosts,thiscreatesdiseconomiesofscale.

WhatYouShouldKnowGoing global greatly improves an organization’s potential to achieveeconomies of scale. That’s often a primary motivation behind acompany’sdesiretoexpandinternationally.As thepriceof an individualproduct increases, thedemand for thatproductwill godown.While thereare someexceptions to that rule, itholds relatively constant. Now, consider the inverse of that. Anorganization’s saleshavestoppedgrowing, so itactually spendsmoneyto increase its production capacity. Why? The company’s executivesknow that by purchasing equipment that can produce a much higherquantityofgoods,thecompanycanchargealowerpriceforthem.Thelowerpriceattractspeoplewhopreviouslycouldn’taffordtheirproductsas well as people who were previously customers of higher-pricedcompetitors. In this way, economies of scale sometimes result in a“natural monopoly,” whereby a single company gains control of a

particularmarketbymakingitsgoodscheaper.All of this increases with the global expansion of an organization’soperations:Thepotentialforinternaleconomiesofscaleincreasesasthetotalnumberofpotentialcustomersgrows;andthepotentialforexternaleconomiesofscaleincreasesasorganizationsexpandthetotalnumberofsuppliersgloballycompetingfortheirbusiness.

WhyYouShouldCareImprovedglobalizationhasallowedorganizationstotakeadvantageofa larger customer base and a greater number of suppliers, decreasingcostsandimprovingoperatingefficiency.Thishasallowedorganizationsnot only to attract customerswith lower incomes, creating a customerbasewhereonedidnotexistbefore,butalsotocompetewiththosefromforeignnationshopingtoenterthelocalmarket.Thebottomlineisthatwhenacompanyachieveseconomiesofscalethroughglobalization,youbenefit.

9.ECONOMIESOFAGGLOMERATION

Whenacompany’soperationsaregeographicallyclosertoitssuppliers,customers,partners,orevenunrelatedorganizationsandcompetitors,itcan experience cost savings; these are called economies ofagglomeration.

WhatYouShouldKnowPeople move to be near their jobs, while organizations move to benear their customers, suppliers, and partners. As a result, everyonebenefits from the group’s ability to efficiently specialize its operations,createsynergy,andevenstimulatebargainingbetweencompetitors.Beingnearsuppliersandcustomersalsoallowsorganizationstomoreeffectively respond to changes in the demand for their products. Evenwhen competitors are located near to each other, the costs ofdistributionformutualsuppliersisreduced,andbothorganizationscanattractawidernumberofcompetingsuppliers.

WhyYouShouldCareNothingstaysconstant,soyouneedtopayattentiontotrends.Wherepeople are locating, where organizations are setting up shop, whatpeople are buying—all these things are very important in globaleconomics.Somethingassimpleasplacingsomeofyourfinancialassetsinanationwithlowerinvestmenttaxescanmakealargedifference.

10.LOCALIZATION

Although it’s counterintuitive, dramatically increasing levels ofglobalizationareactuallybringingaboutanewformof localization. Inorder to fully integrate and improve their competitiveness in foreignmarkets, global companies treat every nation in which they havecustomers as their home country. Today there are four categories ofcompanies:

1. Domestic.Thesecompaniesworkwithinasinglenation,sourcingtheirsuppliesfromwithinitandsellingtocustomersonlywithinthatcountry.Thisincludescompaniesthatpurchasegoodsfromlocalcompaniesthatweremanufacturedabroad.

2. International.Aninternationalcompanyisheadquarteredinasinglenation,buthasimportorexportoperationsthatgiveitapresenceinothernations.Thiscategoryincludescompaniesthatselltheirproductsonlineandshipinternationally.

3. Multinational.Amultinationalcorporationisonethathasaphysicalpresenceinmultiplenations.Thefirmmayactuallyownaforeignbranch,mighthaveaforeignpartnership,mayhaveforeigninvestments,orcouldhaveanynumberofotherformsofarrangementsinplacethatgiveitfullorpartialownershipoverinternationalfunctions.

4. Global/Transnational.Globalcompaniesarethosethatlackahomenation.Theykeepmultiplepointsofcontrolatdifferentlocationsontheplanetinordertostayresponsivetothelocalmarkets.Theyoftenofferstockinseveraldifferentnations,havegeographically

diversemanagement,andsometimesevenlackasingleformalheadquarters.Thisisdonesothateachmarketreceivesspecializedattentionandtheunitsofthecompanythatareconcernedwitharegionalmarketcangivethatmarkettheirfullattention.

Noticethatasacompanyprogressesfromadomesticfirmtoaglobalone, it expands its offering of goods to theworld thatwere originallymeant to attract domestic customers. Organizations tend to graduallyintegrate themselves into foreign markets, so that the pinnacle oforganizationalglobalreachbecomestotalmarketintegrationratherthanmerelyglobalreachofsales.Thisisthenatureoflocalization.

WhatYouShouldKnowThe phrase “Think globally, act locally,” attributed to town planner

and social activist Patrick Geddes, perfectly captures the idea oflocalization. Even the largest of international companies can remainsuccessfulbymaintainingacohesive,coordinatedorganizationthatisasdiverseasitscustomers.Inthismanner,itremainsasingleglobalentitythatmeets thevaryingneedsof local communities,both in itsproductportfolioanditsabilitytomaintainalocalpresenceandmoreeffectivelymanageoperations.As already noted in topic 7, Variety Versus Regionalization,

organizationsofallsortstrytobeasresponsiveaspossibletolocaltastesandtrends.Forinstance,inthosenationsthathaveaprimarilyMuslimpopulation, the Red Cross changed its name to the Red Crescent, thecrescentbeingacommonlyusedsymbol fromthe Islamicreligion.Theorganization still provides the same basic services, but it changed itsimageslightlytoaccommodatetheneedsofthelocalregion.Inordertomanageaproductportfoliothatisdiverseenoughtoremaincompetitiveonagloballevel,andtocontinuouslymanagethatportfoliotokeepupwith changing trends and ideas globally, each region is often given acertaindegreeofautonomytorespondtolocalizedneeds.The concept of localization also extends to the operations of the

company.Globalandmultinationalorganizationstendtodispersetheirmanagementandcoreoperationsacrossawidegeographicregion.Inthepast, a companywould send individuals or entire departments to live

abroad, sometimes for years at a time. They found that this wasn’tentirelyeconomical;norwasitentirelyeffective.Foreignersattemptingto work in another nation, particularly as managers, often have adifficult time relating to the localpeople. So the trendhas changed tohiring local people andmaintaining at least one individual from eachnation in which the organization has a presence in executivemanagementorontheboardofdirectors.Sometimeslocalizationisrequiredbythelawsofthenationinwhich

acompanyoperates. It isnotuncommonforagovernment tostipulatethatanorganizationoperatingwithinitsbordersmusthireaminimumpercentage of locals and invest locally. These types of regulations aremotivatedbyadesire tostimulateeconomicgrowthwithin thenation,thoughtheylimitacompany’sabilitytomanageitsearnings.

WhyYouShouldCareAsaresultofglobalization,manyorganizationsarechangingtobetter

reflectthecultureandideasoftheworld’spopulationratherthanthoseof theirhomenation.Global economics is composedof farmore smallbusinesses thanhuge ones, and operating globally is oftennot so verydifferentfromoperatingdomestically.Consider a single Chinese family that farms pearls from oysters and

sellsthemtotourists.Onetouristrecognizestheopportunitytopurchasethe pearls cheaply in bulk and develops a close relationship with thefamily. Later he forms a company and distributes catalogues of pearljewelryinhishomenationoftheUnitedStates.Thiscompanyownsnoactual factory,hasa staffofonly sixpeople,andsells retail jewelryatwholesale prices across the entire United States. It’s an internationalcompany.Ittakesadvantageofcomparativeadvantageandeconomiesofscale,andalthoughitoperatesglobally,itthinkslocally.Thisisthebestfaceofglobaleconomics.

CHAPTER2OrganizationsofGlobalEconomics

Theyarehugeandinfluential.Theyproduceominous-soundingresearchandrefertodatathatfewpeopleactuallyseeandtoexpertswhomfewpeople actuallymeet. They hold closed-door conversations and brokerdealsamongleadersinworldpolitics,business,andtheintellectualandculturalelite.It all sounds very secretive, as if shadow societies of faceless

organizations are manipulating worldwide economic events.Commentators have speculated that these organizations are exploitingentire nations of people for the benefit of a handful of individuals. Isthere a basis for this? Do these international organizations, whichcontributesogreatlytotheinfluencesoftheglobaleconomy,trulyhideinthedarkcornersoftheworld,plottingtheexploitationoftheworld’spopulation?The short answer is no. Much of the confusion surrounding the

organizations of global economics results not only from the sheer sizeandvolumeof theiroperations,but fromtheir language,whichcanbeincomprehensibletoallbutaselectfew.This chapter will describe the biggest and most important

organizationsinglobaleconomics,includingtheiroriginalmissions,howthey’veevolvedovertime,howtheyhelp,howtheycanbeharmful,and(mostimportantly)howtheyinfluenceyourday-to-daylife.

11.WORLDTRADEORGANIZATION

After World War II, there was—understandably—a very strongawareness among people and governments around the world about

internationalcooperation,coordination,andcommunication.Discussionswereheldconcerningeconomiccooperationand integration,which setrules for the interactionofnations and their peopleboth inpeacetimeandinwar.Organizationswereformed,andmanyofthemostadvancedindustrial nations determined an interest in maintaining a globalpresenceandactivelyparticipatingintheworldcommunity.Perhapsnotall nations were on good terms with each other—the Cold Wareffectively began in 1947—but every nation now understood theimportance of establishing some universally accepted set of principlesthattheworldshouldrespectandbywhicheachshouldabide.One of the largest, most influential, and most successful of theorganizations that evolved from the discussions of this periodwas theWorldTradeOrganization (WTO).TheWTOwas formallyconvened in1995, but its origins lie in a series of treaties called the GeneralAgreementonTariffsandTrade(GATT)thatwasestablishedafterWorldWarII.AnynationthatagreedtothetermsofGATTwouldincreasinglydecrease trade restrictions, eliminate a huge proportion of tariffs, andpromotefreetrade.The1986roundofGATTtalkslaidthefoundationsof theWTO as an organization to promote and facilitate the goals ofGATT,toprovideaforumformembernationstodiscussissuesintrade,to enforce GATT and WTO rules for member nations, and to resolvedisputesthatarisebetweenmembernations.To date, theWTO has been highly successful at achieving its goals,and157nationsintheworldmaintainactivemembershipinit.

WhatYouShouldKnowThe primary function of theWTO is to increase free trade betweennations. It does this by requiringmember nations to adhere to certainrules; member nations are entitled to certain benefits and guaranteedequal treatment by othermembers. There are five broad principles bywhichtheWTOoperates:

1. Nondiscrimination.AllmembernationsoftheWTOandtheirproductsmustbetreatedequally.

2. FreeTrade.Overdecades,negotiationsbyWTOnationshaveremovedbillionsofdollarsworthoftariffsandtraderestrictions.

WTOmembernationscontinuetoworktowardremovingbarrierstotrade,increasingthefreemovementofpeopleandcapitalacrossinternationalborders,andincreasingeconomicintegration.

3. Predictability.NationsthatagreetothetermsoftheWTOandtoanyothereconomicagreementswithintheWTOforumalsoagreethattheiragreementisbinding.Theywillallowtransparencysothatotherscaneasilyseethateachnationisupholdingtheirpartoftheagreement.

4. FairCompetition.Inadditiontofreetrade,theWTOalsorequiresfairtrade.Fairtrademeansthatnationsadheretorulesthatdonotallowforpredatorybusinesspractices.

5. EncouragingDevelopment.ThosericherWTOmembernationsandtheWTOitselfcontributeexpertiseandencouragementtosmaller,poorer,andless-developednations.Whiletheorganizationdoesn’tprovideloansorotherformsofdirectinvolvement,thesenationsareoftengivenadditionaltimetomaketheeconomictransitionsrequiredbyWTOregulations.

WhyYouShouldCareTheWTOsetstheguidingprinciplesandactsastheintermediaryforthevastmajorityofinternationaltrade.ThenegotiationsthatresultedinGATT and the WTO dramatically increased the volume and value oftrade, reducingcostsof tariffsandotherbarriers to trade,encouragingimportsandexports rather thaneconomic isolation.Since themajorityof all nations in the world are WTO members, including the largesteconomiesintheworld,anytimeaneconomicconflictarises(whichisfrequently)betweenthesenations,theWTOmustnegotiatearesolution.The WTO does, in fact, have the ability to bind nations to penalties,fines,andcorrectivemeasures.IftheoffendingnationdoesnotadheretotherulesordecisionsoftheWTO,itsmembershipcanberevoked.

12.WORLDBANK

Startedin1945,theWorldBankis,asonemightexpectfromitsname,a

bank for nations. It provides loans, facilitates exchanges andtransactions, generates interest, and performs other banking functions.TodaytheWorldBankactuallyconsistsoffivedifferentorganizations.

1. InternationalBankforReconstructionandDevelopment.Thisbanklendsmoneytonationsforthepurposesofinfrastructuredevelopment.ThefirstloanwasissuedtoFranceforreconstructionafterWorldWarII,butthescopeofloanshasexpandedtoassistwithanyformofinfrastructureconstructionforthepurposesofnationaleconomicdevelopment.

2. InternationalDevelopmentAssociation.Thisbankalsolendsmoneyforthepurposesofdevelopment,butratherthaninfrastructureconstruction,thisbanklendsmoneytoverypoornationstouseinmakingavailabletotheirpeoplethingssuchasmedicalcare,schools,utilities,andotherbasicsoflife.

3. InternationalFinanceCorporation.Thisorganizationislessabankandmoreafinancialadvisoryfirm.Ratherthanlending,itoffersinvestmentservices,financialadvisoryservices,andassetmanagementservicestogovernmentsandtheprivatesectorinordertohelpstimulateprivate-sectordevelopmentinleast-developednations.

4. MultilateralInvestmentGuaranteeAgency.Sincepoorernationsholdgreaterriskforinvestorsintheformofpoliticalvolatility,thisbranchoftheWorldBankinsuresprivateinvestorsagainstsuchrisktohelpattractmoreinvestments.Ratherthanallformsofinvestment,however,theagencyinsuresonlynewinvestmentsthatwillhaveanimpactonthenation’sdevelopment.

5. InternationalCentreforSettlementofInvestmentDisputes.ThenameofthisparticularbranchoftheWorldBankprettymuchsaysitall;thisbranchprovideslocationsandarbitrationservicesforthemembernationsoftheWorldBank.

WhatYouShouldKnowAlltheorganizationsoftheWorldBankrequireborrowingnationsand

organizationstoundergoevaluationandmaintaincooperationwiththe

WorldBanktoensurethattheiruseoffundsisresponsibleandthattheytakepositivestepstowardeconomicreform.Thishasdonetwothings:

1. Ithashelpedmanynationstakepositivestepstowardachievingsustainabledevelopmentandeconomicgrowth.

2. Ithasattractedalotofcriticismandconspiracytheoriesabouttheactualintentoforganizationsthatlendmoneyinreturnforpoliticalreform.

ItiswidelyacceptedthattheWorldBankhasimproveditssuccessratefor lending programs that develop into sustainable programs and paybacktheirloans.Still,thatrateisonlyabout30percent.Whataboutthefailures?Insomecases,therehavebeeneconomicshocksasthehugeinfluxofinvestmentcreatesvolatilitytowhichmanyimpoverishednationscan’tadjust.Inothers,therehasbeenlittlestableeconomicandinfrastructuregrowth,andpoornationsfindthemselveswithadebttheycannotrepay.ThishasledmanytobelievethehiddenintentoftheWorldBankistogaincontroloverpoornationsforthebenefitofrichercountries.

WhyYouShouldCareTheWorldBankisfundedbyitsmembernations.Youshouldjudgeitssuccessbasedonwhetherthebankcreatesglobaleconomicbenefitequaltoorgreaterthanthecostofsustainingit.Asnoted,ithasimprovedinits success rate, which is promising, and the work it does is veryimportant.Butunlessthebankcanprovethatitcancontinuetoimproveitssuccessrateandactuallystimulatenationaldevelopmentinstrugglingnations, then thatwillput the legitimacyofall fiveof theWorldBankinstitutionsintoquestion.

13.INTERNATIONALMONETARYFUND

The International Monetary Fund (IMF) was first established at theBrettonWoods Conference in 1944 and began operations in 1945. Itsgoalwas,andstillis,tomonitortheeconomicconditionsofitsmember

nations and take steps to prevent avoidable and short-term economiccrises. Originally that meant managing the fixed-exchange-rate policybetween nations (that is no longer applicable since the majority ofnations nowuse floating currencies) and helping to rebalance nations’current accounts in their balance of payments. However, it no longerperformseitherofthesefunctions.Today the IMF still closely monitors the economies of its member

nations, providing information and data to the other nations to helpeachcoordinatetheirdomesticandinternationaleconomicpolicies.TheIMFworkswithnations to provide technical assistance in the areas offiscal andmonetary policy, increasing trade and economic integration,attracting investment, and banking. In extreme cases, the IMF willprovideloanstothosenationsthatareexperiencingashort-termcrisis.AswiththeWorldBank,theIMFhasattractedasignificantdegreeof

controversy as a result of requiring political reforms for borrowingnations. The IMF has also come under fire for a number of otherproblems,specificallymultiplebackfiredattemptsatdevelopmentintheareasoffood,medicine,theenvironment,freetrade,andhumanrights.Still,theIMFinsiststhatitssuccessesoutweighitsfailures.

WhatYouShouldKnowTheIMFhasbeencriticizedbyexternalsourcesaswellasmanyofits

own economists for adopting a growth-at-all-costs policy. Many alsoclaim that adherence to the conditions set on loans issued by the IMFhaveledtoepidemicsofdiseasessuchastuberculosisandHIV,extensivedamagetotheenvironment,poormanagementoffoodproduction,andother harm. IMF, critics say, starts from the idea that all economicsectors shouldbe industrializedand thatmanufacturing for thesakeofoutsourcing should be done, regardless of the secondary harm caused.That philosophy extends to several of their economic policyrecommendations. Their methods of currency devaluation to attractexportsanddecreasinginvestmentandeconomicstimulusduringtimesof economic crisis have proven to be extremely harmful to the globaleconomy.TheIMFstatesthat itsrole intheglobaleconomyismoreimportant

andbeneficialthananymistakesit’smadealongtheway.Tobackthis

claim, it points out that it has significantly helped several nations inSouth Americaminimize the impact of economicmismanagement andhelped other nations privatize their industries and move away fromclosedorstate-controlledeconomies.

WhyYouShouldCareThere’sasaying:“Nevertrustapersongivingyouinvestingtips.”Toa

largeextent,that’strueoftheIMF.Somecountrieshaveconcludedthatwhile the IMF can provide a useful service, many of its policies andeconomic ideas are out of date and flawed. Since the IMF onlyworkswithgovernments,howcanthispossiblyinfluenceyou?Well,everyoneintheworldisunderthecontrolofonegovernmentor

another, and those governments will influence your life.Whether youandothersaroundyoubenefitfromIMFinvolvementthroughastrongerandmore stable economywill dependonhoweconomically savvy areyournation’sleaders.

14.ORGANISATIONFORECONOMICCOOPERATIONANDDEVELOPMENT

The Organisation for Economic Cooperation and Development (OECD)was begun in 1948 to create a cooperative effort among EuropeannationstorebuildafterthedestructionofWorldWarII.Then,in1961,itwas reorganized with broader and more abstract goals intended topromote free trade, economic development, and internationalcooperation.Itdoesthisbyworkingcooperativelywithgovernmentsandprivatecompaniesfromaroundtheworld,makingrecommendationsanddeveloping policies for nations (nonbinding, of course, but oftenimplementedorotherwisetakenintoconsiderationbymembernations).Itpublishesbooks,dataandstatistics,referenceguides,researchstudies,andeconomicperformancedata.TheOECDderivesalargeportionofitsauthorityfromitsexpertiseandprofessionalism.

WhatYouShouldKnowThe OECD covers a wide range of topics, from energy to trade to

businessandunions.EverysubjectinglobaleconomicsisstudiedbytheOECD. That is where its activities end, however. The organizationstudies, researches, and makes recommendations. Its only method ofpushingorganizations,publicorprivate,totakeactionisbysupportingits positionwithwell-founded research. Its role is academic, aimed atunderstanding the economic forces at work and suggesting ways tooptimizethemforthebenefitofmembernations.

WhyYouShouldCareYou should care about the OECD for the same reasons thatgovernmentscareaboutit:It’soneofthemostrespectedauthoritiesonglobaleconomicissuesintheworld.Therecommendationsitmakesaretakenseriouslybynationsduringtheformulationandimplementationofeconomicpolicies.TheOECD’sinformationwillhaveaninfluenceontherole of your nation in the greater global economy,which in turnwillaffectyourdailylife.

15.ORGANIZATIONOFPETROLEUMEXPORTINGCOUNTRIES

Oilhasbeenamongthemostimportantcommoditiesintheworldsincethe early twentieth century. For a long time the vast majority of oilproductionwasconfinedtojustahandfulofnations.In1960,manyofthese nations formed an organization called the Organization ofPetroleumExportingCountries,orOPEC,whichnowhastwelvemembernations collectively producing 33.3million barrels of oil per day. ThegoalsofOPECare to represent the interestsof itsmembernationsandtheoil industry,aswellas to stabilizepriceandproductionofoil inamannerthatoptimizeswealthforitsmembers.

WhatYouShouldKnowOPEC isanoligopoly—acartel.Thatmeans that itsmembersdonotcompete with each other. Instead, they cooperate to maintain aguaranteed higher price for their product. This cartel is less powerfulnowthanformerly,ashugereservesofoilhavebeenfoundinnon-OPEC

nations, but to a large extentOPEC’s behavior has already shaped thepriceandoperationsoftheworld’soilindustry,andstillinfluencesthemtoday. OPEC has refused to acknowledge that their reserves are beingdepleted quite quickly and that oil’s high price has encouragedinnovation in alternative energy sources (a free competitive marketwould, of course, lessen the drive toward innovation, since oil priceswouldbelower).OPEC’s members include (in alphabetical order): Algeria, Angola,Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, theUnited Arab Emirates, and Venezuela. Many of these nations relyexclusivelyon theoil industry tosustain theireconomy,andmanyarepoliticallyor sociallyunsettled. In some instancesOPEChas refused toexportoil tonations; inothercases,oilproduction facilitieshavebeenattackedtodisruptsupply.Sinceoiliscriticaltothehealthoftheglobaleconomy,thisvolatilitymakesmanynationsaroundtheworldnervous.

WhyYouShouldCareThe entire economy of nearly every nation on earth relies on oil.Withoutit,theeconomiesoftheworldwouldeffectivelycometoastop.Ensuringthereadysupplyofoilisamongthemostcriticalobjectivesforglobaleconomics.

16.GOVERNMENTS

Everycitizenofeverycountryissubjecttoagovernment.Governmentsmaintaincontroloverall theactivitiesof thepeopleandorganizationswithintheirbordersandrepresentthosepeopleandorganizationswheninteracting with foreign governments. They vary quite a bit in theirdegreeofcontroloverthepeopleoftheirnation,aswellastheirsourceofpower.

DegreeofControl.Thisrangesfromattemptstomaintaintotalcontroloverallactionsandthoughtsofacitizenrytoaguaranteeofcompletefreedomtopursuewhateveractionseachcitizenwants.Theformerextremeisusuallydescribedasatotalitarian

government,whilethelatterisdescribedcolloquiallyasafreesociety.

SourceofControl.Somegovernmentstakecontrolbyforce—say,throughtheuseofmilitaryormercenaryforces—whileothersaregrantedcontrolbypopularvote.Therearemanyintermediatepointsbetweentheseextremes.

Generally speaking, economics should have very little to do withgovernments and politics. Economic relations emanate from humanbehavior as people work to optimize the distribution of limitedresources.Asaresult, theforcesthatgoverneconomictransactionsarenaturalbehaviorsthathavenothingtodowiththegovernmentinpower—unless that government establishes control over some aspect of theeconomy.

WhatYouShouldKnowGovernmentpoliciesmostdirectly related to theglobaleconomyare

those that affect trade and the movement of capital or people acrossinternational borders. These specifically define what types oftransactionsthepeopleandorganizationswithinanationareallowedtoparticipateinwithpeopleoutsidethesamenation.Inadditiontothosepoliciesestablishedtodirectly influencetherole

of aparticularnation and its citizens in the global economy,domesticeconomicpoliciesalsohaveamoreindirectinfluence.Monetarypoliciescan change the quantity and value ofmoney by altering printing anddistributionofacurrencyandchanginginterestrates.Inaddition,fiscalpoliciesmanagetaxation.

WhyYouShouldCareCompaniesaroundtheworldarecompetingtosupplyyouwithgoods

and services. To what degree you have access to them depends ongovernmentpolicies—boththoseofothernationsandyourown.Theeconomicforcesineachnationandbetweennationsinfluencethe

economies of other nations, and because of this, people around theworld are becoming increasingly interconnected. As a result,governments increasingly interact with each other in matters of

economics.Howwelltwogovernmentsrelatetoeachotherandareabletogetalongwilldetermine,toalargedegree,theamountoftradethateachgovernmentwillallowwiththeothernation.

17.NONGOVERNMENTALORGANIZATIONS

When an international organization isn’t a branch of government, acollection of governments, or a profit-seeking company, it’s called anongovernmentalorganization(NGO).Theseorganizationsdon’tfitintoany other category. They often act like government agencies, but theyaren’t directly associated with any government. They act likecorporations,buttheirgoalisnottogeneraterevenues.You’veprobablyheardofmanyNGOswithoutbeingawarethatthey

fall into this category. The Red Cross, for example, is an NGO. TheInternational Organization for Standardization, the organization thatdevelops the standards by which many companies operate, is also anNGO.SoaretheWorldWildlifeFund(WWF),thePeaceCorps,andeventheWikimedia Foundation (the people who bring youWikipedia). Alltheseorganizationshavethreethingsincommon:

1. Theymaintainglobaloperations.

2. Theyareautonomousfromanygovernment(thoughmanyNGOsreceivecontributionsfromgovernments).

3. Theyoperatewithoutanticipationofrevenuesinexchangefortheircontributions.

Well,youmight think, it soundsas ifNGOsare just charities.Whileit’s true thatmany charities are NGOs, that’s not the case with all ofthem. Nor are all NGOs charities. NGOs fall into three primarycategories:

1. Charities.Theseareorganizationswhoseprimaryintentistoprovideservicestopeopleinneedofassistance.ExamplesincludeDoctorsWithoutBordersandOxfam.

2. Professional.Theseareorganizationswhoseprimaryintentistoregulate,coordinate,andpromoteaspecificfieldorprofession.ExamplesincludeW3C(WorldWideWebConsortium)andBNI.

3. Political.Theseareorganizationswhoseprimaryintentistoinfluencegovernments,usuallyfocusedonasingleandnarrowrangeoftopics.ExamplesincludeHumanRightsWatchandTransparencyInternational.

A large number of NGOs cross multiple categories—for instance,AmnestyInternational.Othersdon’tfallintoanysinglecategory.

WhatYouShouldKnowThe ultimate goal of each NGO is to help bring stable growth and

development to thenations inwhich theyoperate.While someseek toimprove the quality of life through specific issues (medicine,environment, human rights, etc.), others attempt to standardizeindustries through the dissemination of information, improvedproductionmethods,andcoordinationandrepresentationthatallowforsaferandmoreinformedtransactions.ItisthegoalofNGOstochangethemarketenvironmentratherthan

themarketitself.ThecontextinwhicheconomictransactionstakeplaceistherealfocusofNGOs.Theyallplayaroleinshapingthenatureandroleoftheorganizationsoftheglobaleconomy.

WhyYouShouldCareSinceNGOsdon’tdirectlyparticipateintheglobaleconomy,theyare

sometimes seen as peripheral, but that couldn’t be further from thetruth.Notonlydothesemassiveorganizationscontrolalargevolumeofassets—all purchased from different companies and different nationsfrom around the world, thereby exerting economic influence throughtrade—but they also play a strong role in shaping public opinion andgovernmentpolicy.NGOsworkcloselyalongsidegovernmentagencies,evenoftenbeingtherecipientsofgovernmentfunding,toachievetheirgoals.

18.MULTINATIONALCOMPANIES

Multinational companies have operations in multiple nations. Theseoperations can be of varying complexity, ranging from simpleimport/exportatoneextremetomultipleheadquartersandstaffsattheother.Whatmakesmultinationalcompanies(MNCs)differentfromothercompanies is that, over the centuries, firms have increased to a sizeunprecedentedinhistory.Theycommandavolumeandvalueofassetsunheard of before our era, and they are often sought after bygovernmentagenciesforconsultingrolesonpolicyquestions.MNCsareoneoftheprimaryinhabitantsoftheglobaleconomy.Not

onlyaretheybyfarthemostsignificantsupplierofgoodsandservices,driving the production of a nation as theywork tomeet the needs oftheircustomers,butcollectivelytheyalsorepresent theprimarysourceofemploymentandmanagethevastmajorityofthemovementofcapitalandgoodsaroundtheworld.Customersare,ofcourse, thecounterparttocompanies;customersrepresent“demand”whilecompaniesrepresent“supply.”

WhatYouShouldKnowTheprimaryroleofcompaniesistoproducethegoodsandservicesfor

whichpeoplearewillingtopaymoney.Theultimategoalofacompanyis to improve its financial performance by cutting costs, increasingrevenues, and performing operations more efficiently. Internationaltradeandinvestment,aswe’veseen,helpthisprocess.

WhyYouShouldCareFor our purposes, all businesses are multinational businesses in the

sensethattheyallhaveaninfluenceonglobaleconomics.Assuch,theyintimatelyconnectustotheworldandimpacteveryaspectofourlives.It can be easy to become overwhelmed by the immense size andoperationsofamultinationalcompany;infact,MNCs,attheirheart,aresimpleentitiesthatexistforonereason,andonereasononly:tomakeaprofit.

19.G8SUMMIT

Welcome to the world’s most exclusive club: the G8 summit. Notofficially an organization, the G8 is a collection of eight of the tenlargestnationsintheworld,measuredbygrossdomesticproduct(GDP).Theeightmeetforanannualsummittodiscusstopicsofglobalconcernsuch as trade, climate change, energy, and other issues in globaleconomics.AlthoughtheG8isjustaforumforrepresentativesfromthesenations

to talk, their regular interactions, ability to make and commit todecisions during the summits, and follow-up on the subjects discussedmaketheG8summitmoredurableandgiveitmoresustainedinfluencethanoriginallyintended.Thenations beganmeeting in1975 as theGroupof Six, orG6, and

included France, Germany, Italy, Japan, the United Kingdom, and theUnitedStates.Latertheyaddedtwonations,CanadaandRussia,makingthem the G8. The G8 includes only the largest and most developedeconomies in the world. China and Brazil, although within those topeconomies,arenotincluded,andtheEuropeanUnionisrepresentedbutdoesnotholdachairatthesummits.The G8 does not have a permanent office or administration. The

meeting location and office of president rotate every year among thedifferentmembernations.Theexactgoalsandsubjectsdiscussedatthesummitvarydependingonthepoliticalgoalsoftheindividualmembernations. Although fluid, the topics are always focused on large globalissues that require a unified effort among multiple nations. Althoughthere isnoobligation tocometoanagreementonanyparticular issueduring the summit, theaim is todiscuss theseeconomicquestionsandcometoaconsensusonhowtomoveforward.

WhatYouShouldKnowAgreementsandtreatiesaren’trequiredfromtheG8summit,butitis

politicallyusefulfortheleadersofthemembernationstoshowthattheyaremakingprogressonpressingissuesandthattheycanworktogetherto forma consensus onhow to resolve theproblems.Those issues not

readily resolvedareoften followeduponby smallermeetings toworkoutthedetailsandlogistics.At the thirty-eighth G8 summit in 2012 participants agreed to thefollowing:

EnergyandClimateChange.Membernationsagreedtopursuemoreaggressivetransitionstorenewableenergy,toreducetheuseoffossilfuelsforenvironmentalpurposes,andtoreducetheeconomicvolatilityassociatedwithshocksinthepriceandsupplyofoil.

FoodSecurity.TheG8nationsformedwhattheycalleda“newalliance”withthenationsofAfricatohelpdevelopaninfrastructureforagriculturalproductionanddistributionintendedtoholdoffstarvationandreducethenumberofpeoplelivinginpovertybyapproximately50million.

MiddleEastDevelopment.ParticipantsagreedtofinanciallysupporttheArabSpringandworktowardreducingpoliticalandsocialvolatilityintheregion.

Notalloftheseitemsrefertoagreementsandalliances,butthisforumallows the decision-makers of each nation to freely communicate ontheseproblemsinasinglelocationwiththepurposeofsettinggoals.

WhyYouShouldCareJust because it’s unlikely that you’ll participate in the G8 summit,don’t think that you don’t play a role in the topics addressed and theactions taken by those representing your nation. These people arepoliticians, and their ultimate incentive is self-serving. Issues that areimportantduringanupcomingelectionare theones thatwillbegiventhemostattentionatthemeeting.TheimpacttheG8summithasontheglobaleconomyshouldbeobvious.Thelargestnationsintheworldbyeconomicsizeworktofindresolutionstothebiggesteconomicproblemsof the era. The exact influence, however, will depend on the subjectsthatareaddressed.

CHAPTER3BalanceofPayments

Exportsleaveonecountryandimportsenteranothercountry;ownershipofcapitalassetsisexchangedtimeandagainacrosstheglobe.Allofthishappens in varying quantities and prices, and for each nation it isrecordedandaddedupinahugerecordcalledthebalanceofpayments.The balance of payments, often referred to as the BoP, is a detailed

accountingofthevalueofallinternationaltransactionsforacountry.Itis broken down into three primary elements: the current account, thecapital account, and the transfer payments account. The transactionsrelevanttoeachaccountarethenfurtherclassifiedaccordingtothetypeofgoodsorservicesbeingexchanged.

1. Thecurrentaccountincludesallimportsandexportsofgoodsandservices.Withinthecurrentaccountaresuchcategoriesasmanufacturedandassembledgoods,andservices.

2. Thecapitalaccountincludesalltransfersofcapitalownership.Withinthecapitalaccountarereserveassets,foreigndirectinvestment,andanyotherformofownershipstakethataforeignnationmightholdinanothercountry’seconomicwell-being.

3. Thetransferpaymentsaccountdealswiththosetransactionsinwhichgoodsorcapitalaregivenfreelytootherswithoutcompensation.Thisaccountissometimesreferredtoasthebalancingaccount.

The primary principle of the balance of payments is that it mustalways (as thename implies) balance.This happens through aprocesssimilar to double-entry accounting: Each international transactioninfluencesthevalueoftwoBoPaccountsforeachnation.Anytimeoneof the accounts in the balance of payments changes value, a different

accountchangesinvaluebythesameamountbutintheoppositedirection.Forexample,ifthecurrentaccountincreasesby$35million,thenoneofthetworemainingaccounts(capitalortransferpayments)mustdecreaseby$35million.On a smaller scale, of course, this happens in any transaction. Forinstance,whenyoubuya$35bottleofgin,youreceivetheginbottleinwhatwouldbeacurrentaccounttransaction.Younowpossessabottleofginthatincreasesby$35yournetworthingoods.Yougivethestoreowner $35 in cash, a capital account transaction (you’re effectivelytransferring some of your capital to the liquor store owner) thatdecreases your available capital by $35. If, by somemiracle, the storeownerdecidestosimplygiveyouthegin,thenthetransactionrepresentsa decrease in the transfer payments account and an increase in yourcurrentaccount, thusbalancingtheBoP(this is thereasonthe transferpaymentsaccountissometimescalledthebalancingaccount).Theexactvaluesofacountry’s threeaccountsdon’t reallymatterasmuchas theoverallhealthof itseconomy.This isdespite thefact thateconomic commentators use the term “imbalance” to describe anycurrentaccount thathasavalueother thanzero. (Keep inmindthatacurrent accountwith a valueof zerowould require anation to exportexactlyasmuchas it imports.Thisneveroccurs,evenamong themostisolatednationsintheworld.)TheonlyimportantthingabouttheBoPisthat the total, when you add up the values of all the accounts, mustequalzero.It’snotimportantthatanysingleaccountshouldequalzero.The balance of payments is used, primarily, to keep track oftransactions that take place internationally. It helps guide economicactivities for governments and organizations in a given nation. Theinformation provided by the balance of payments is critical tounderstandingandprojectinganation’scompetitiveness inthetradeofproducts from particular sectors. It also helps in managing andestimating movements in exchange rates and evaluating the overallhealthoftheeconomy,particularlywhenusedinthecontextofdomesticinflationary and unemployment rates. Understanding the volume andtypesoftransactionsandinvestmentsthattakeplacewithinanationisabitlikefindingtheedgepieceofapuzzle:It’sagreatwaytogetanideaofwhattheoverallpicturewilllooklike.

20.CURRENTACCOUNT

Whenpeoplethinkofmeasuringtrade,theyareusuallyjustthinkingofthecurrentaccount.This,asIexplainedpreviously,istheportionofthebalanceofpaymentsthatmeasuresthevalueofgoodsandservicesbeingimported intoandexportedfromanation.Thinkofyourowncountry;oddsarethatitbothimportsandexportsgoodsandservices.Exportsaddvaluetothecurrentaccount,whileimportssubtractvaluefromit.Goodsare those things thathaveaphysical form.Theymay includeconsumergoods,suchasItalian-madecarsorJapaneseelectronics(thatis,productsdirectlyusedbyconsumers).Theycanalsoincludebusinesscapital goods such as machinery (that is, products that are used toproduceotherproducts).Ortheycanincluderawmaterialssuchassteelorcoal.Servicesareactionsforwhichpeopleororganizationsarepaid.Theyprovidevaluetothecustomerbutnophysicalproduct.Commonservicesthataretradedinternationallyincludetransportation,research,medicalprocedures, research, and teaching. These things all provide value topeople in other countries and must, therefore, be recorded on thebalanceofpaymentsascontributingtothevalueofthecurrentaccount.Adecreaseinthecurrentaccountisalmostalwaysassociatedwithanincrease in the capital account (discussed further in topic 21, CapitalAccount), and vice versa. This is in the nature of current accounttransactions, which, more likely than not, infer cash transfers in theotherdirection.Inotherwords,ifyoubuysomething,thecompanyfromwhichyoupurchaseitwillusuallywanttogetpaidincash,evenifthatcompanyhappenstobehalfwayacrosstheworld.

WhatYouShouldKnowIf you’ve ever shipped a package or even mailed an envelopeinternationally, you filled out a form about the type of goods beingshipped, theirvalue, andanumberofotherpiecesof information thatthe customs officials in a nationwill want to know before they allowsuchapackagetoentertheircountry.Theseformsareaprimarysourceofinformationforthegovernmentagenciesthattracksuchthingsabout

goods thatarecoming inandoutofyourcountry.Services, since theyoftendonotrequireshipment,areabittrickiertotrack.This tracking system with its multiple forms isn’t always entirely

accurate. For instance, small companies and individuals tend to reportlowervaluesorpricesongoodsthey’reexportinginordertoavoidbeingcharged a tariff (a tax on imports) by the government of the countrythey’reshippingto.Governmenttrackingofimportsandexportsappliesto everyone, no matter how big or small their shipment, when theytransfergoodsbetweennations.Governments can somewhat compensate for the deviation on

estimatedvaluesofimportsorexportsbyusingothermeasures,suchasthoseusedwithservices.Servicesusemostlytaxstatementsfortracking.If youwork overseas, you’re probably aware that there’s a portion onyourU.S.taxformsthatasksaboutforeignincome.Thegovernmentalsomeasures the number of people who enter the country, where they’restaying(whetherwithfamilyornot,geographiclocations,etc.),andhowlongtheystay.Companiesthatshiporreceivegoodsfromoverseastracktheseshipmentsaswell,bothformanagementpurposesand,quiteoften,fortaxpurposes.The information derived from the current account is, by itself, very

limited. Since changes in the balance of payments always affect twoaccounts,lookingexclusivelyatthecurrentaccountdoesn’ttellusmuch.However, a positive or negative balance, particularly if it has anextremelyhighvalue,canprovidesomeinformationaboutthehealthoftheeconomy.Usedinconjunctionwiththecapitalaccount,informationderived from the current account can help project future changes in anation’strade,andevenhelpidentifysomeofthebroadsectorsthatareinfluencedbytradeinordertoinferthoseindustries inwhichanationhaseitheranadvantageordisadvantage.

WhyYouShouldCareThedegreetowhichanationimportslessthanitexportscantellyou

critical details about the sources of domestic unemployment andinflationaswell as the comparative economic statusof twonations. Itcan even guide domestic fiscal and monetary policy. Companies alsopickuponthesedetailsastheysearchoutopportunitiestocutcostsor

increaserevenuesbyexpandingtheiroperationsinternationally.Let’s say our country is a very large net importer but also has highunemployment. This situation could indicate that the foreign nationsexporting goods to us have an advantage over us in the production ofthose goods—for example, their labor costs may be less than ours. Ifthat’sthecase,andyouworkinanindustrythatproducesgoodsthatarebeing imported in largenumbers, look fordownwardpressureonyourwages.

21.CAPITALACCOUNT

Thecapital account is theotherhalfof themajorityof exchanges thattakeplace in thebalanceofpayments.Anytimea storebuysor sells aproduct, it’s not just the product or service itself that changes hands;there’s also a change in an agreed-upon value of capital ownership.Remember our example of the bottle of gin selling for $35—thestorekeepergivesyouthebottleofgin(increasingthevalueofgoodsinyour possession), and you give him $35 (increasing the amount ofcapitalinhispossession).This same basic system is true for trade between nations. When anationexportssomething,inreturntheyreceivecurrency,orsomeotherformofcapitalcompensation,forthegoods.Anytimeanationincreasesits ownership of capital from another nation, that’s included on thecapital account. If that same nation decreases its capital, giving it toanothernation,thenthatdecreasesthevalueofitsowncapitalaccount.The capital account, in other words, measures changes in capitalownership.These changes can includemoney earnedand spent from the exportand importofproductsand services (those things found in thecurrentaccount). But the capital account also measures investments in othernations through the purchase of companies, opening branches ofcompanies, or investing in the stocks and bonds of that nation. Adecrease in the capital account is almost always associated with anincreaseinthecurrentaccountandviceversasinceanationdoesn’tgive

away capital without receiving something in return. Often such anincrease is in the form of cash, but itmight also come in the formofdevelopment,suchastheconstructionofafactory.

WhatYouShouldKnowThe capital account is a summary of the investments that occur

between nations. It includes foreign direct investments (which occurwhenacompanyopensabranchorsubsidiaryinaforeignnation,eitheraloneoraspartofsomelevelofpartnershiporjointventure),purchasesandsalesofstocksandbonds,andlandownership.Anythingthataltersthe ownership stake in a nation’s economic future across internationalboundariesisincludedinthecapitalaccount.Cash,initself,isaformofinvestmentinanothernation.WhenNation

A gives Nation B goods in exchange for Nation B’s currency, thatcurrencyisacceptedbecauseNationAisconfidentthatitwillbeabletouse that currency at somepoint in the future to receive an amount ofgoodsequaltoorgreater invaluethantheamountofgoodsitgavetoobtainthatcurrency.Thisiswhythepeopleofonenationhavereasontowishtheeconomyofanothernationwell—theywanttoreceivesomepositivereturnontheirinvestment.The information derived from the capital account gives a couple of

interestingpiecesof informationabout anation’s currency, its growth,its international interdependence, and its overall ability to attractinvestments. For example, if we know that Nation A has a very highcapital account surplus but a high exchange rate relative to an exportpartner, Nation B, we might predict that Nation A’s currency willdecrease invalue relative toNationB, sincedemand for that currencywilldecreasealongwiththelowerdemandforNationA’sgoods.

WhyYouShouldCareDespitebeingatleastasimportantasthecurrentaccount,ifnotmore

so,thecapitalaccountgetsverylittlepublicattention.Asaresult,thereis a lot ofmisconception about the very nature of trade itself; peoplelook only at the current account and forget about the relatedinvestmentsthatoccur.Youshouldcareaboutthecapitalaccountbecauseitfillsinthesecond

halfofthebalanceofpayments,providingthefullpictureofanation’sinternationaltransactions.Thisalonegivesyouabetterunderstandingofhowtradeinfluencesyournation.Theinformationderivedfromthecapitalaccountalsoprovidesaview

oftheflowofinvestmentsthatanationisexperiencing,allowingpeopletoproject futurecross-national investmentpatterns.This isparticularlyimportantforinvestors,butitalsoallowscompaniestoconsidermeansof raising capital, or to help individuals project changes in exchangerates.Aswithusingotherportionsofthebalanceofpaymentsforeconomic

projections,it’simportanttorememberthatthisisonlyonesmallpieceofthepicture,asinglelandmarkonalongroadtrip.Still,whenitcomestomoneypeopledon’tliketoscrewaround,souseallthetoolsavailableto you, particularly when it comes to domestic policy that influencesyourabilitytoearnaliving.

22.TRANSFERPAYMENTS

Thefinalportionofthebalanceofpayments isoftenreferredtoasthebalancing account. This is the portion that accounts for unilateraltransfersbetweennations.Sometransactionsoccurinwhichsomethingof value is given without any reciprocation; this is called a transferpayment.Sincethebalanceofpayments,asawhole,mustbalance,anytransactions of this type will have an impact on either the capital orcurrentaccounts,butnotboth.Thebalancingvaluethatmakestheentirebalance of payments equivalent is included in the transfer paymentsportionofthebalanceofpayments.

Ifatransactionthataffectsthetransferpaymentsaccountinfluencedthecurrentaccount,itmeansthatthenationeithergaveorreceivedgoodsand/orserviceswithoutexpectationsofprovidingsomethingofequalvalueinreturn.

Ifatransactionthataffectsthetransferpaymentsaccountinfluencedthecapitalaccount,thenthenationeithergaveorreceivedcapital

ownershiporsomeformofinvestmentownershipwithoutdoinganythingtoearnthatownership.

WhatYouShouldKnowOnly a very narrow set of transactions fall within the transferpayments. Still, despite being very limited in scope, they occurfrequently around the world. Emergency assistance is probably theclearestexampleofsuchatransaction.TheaidtheUnitedStatessenttoHaiti after the 2010 earthquake was a form of transfer payment. TheUnited States shipped food, clean water, and medical supplies to thestricken nation without expectation of receiving any payment. Such atransactionhadanimpactonthevaluesofboththecurrentaccountandthe transferpaymentsaccount,but since theUnitedStates receivednoownershiprightstocapitalinexchangeforthosegoods,thetransactiondidnotinfluencethecapitalaccountatall.Similar transactions that influence the transfer payments accountcould include themovement of capital betweennations that aren’t fortransactions reasons. For example, if Canada were to provideSwitzerlandwiththerightstoabitoflandinordertobuildanembassy,this would fall within transfer payments. In the case of a privatecompany, this sort of transactionmight take the form of a transfer offundsbetweentheparentcompanyandaforeignsubsidiary.

WhyYouShouldCareThisaccountmaychallengewhatyouthinkyouknowaboutthetradeofyournation.Althoughinformationabouttransferpaymentsisn’tveryuseful by itself, given that it doesn’t have any direct application tonormaltrade,itdoesplayaroleinyournation’sbalanceofpaymentsasawhole.

23.TRADEIMBALANCE

When people talk about trade imbalances, they are really referring toeither a positive or negative value in the current account. A tradesurplusoccurswhenanationexportsmoregoodsthanitimports.Asof

thiswriting,Chinahastheworld’slargesttradesurplusbecausetherestoftheworldpurchasesfarmoreChinesegoodsandservicesthanChinabuysfromtherestoftheworld.Intheoppositedirection,atradedeficitoccurswhenanationimportsmoregoodsthanitexports.TheUnitedStatescurrentlyhastheworld’slargest trade deficit because it purchases far more goods and servicesfrom other nations than it exports. The vast majority of tradetransactions,however,arebalanced.

WhatYouShouldKnowThe very term “trade imbalance” ismisleading, as it implies that intrading, one nation benefits at the expense of another. Except fortransferpayments,whichtypicallyrepresentaninsignificantproportionof a nation’s total trade, in the long run the value exchanged betweennations isequal.(Atleastanexchangeofvalueissoclosetoequivalentthat the only people really concerned with the difference areprofessionaleconomists.)Youmay find this concept abit strange.After all, isn’t internationaltradelikeourownspendinghabits,writlarge?Ifanationismaintainingatradedeficit,thenisn’titspendingtoomuchmoneyonimports?Well,no.The thing that trulymatters is notwhether your nation has a tradedeficit or not, but what that trade deficit is funding. Don’t think ofimportinggoodsandservicesintermsofconsumerspending;instead,it’slikecapitalinvestmentusingaverybigcoupon.Forinstance,NationAtakesadvantageofthelowercostsandhighervolume of goods obtained by importing from Nation B, which has anadvantageinaparticularsetofgoodsandservices.NationAthenusesthose imports(whichcreatedatradedeficit) tocreateothergoodsandservices of value; in other words, Nation A improves its return oninvestment.If a company purchases a machine from some other company, wecould say they’re giving money to the other company rather thankeeping it. But in the long run they have increased their productionefficiency and future production potential. They’ve concentrated on

what they’re good at. This allows them to attract buyers of theirproducts. In the same way in our example above, Nation B uses itsreservesoftheforeigncurrencyithadpreviouslyreceivedfromNationAtopurchasethatnation’sexports.(RememberwhatIsaidbefore:Inthelongrun,internationaltradeisazero-sumgame.)Althoughatradesurplusistheoppositeofatradedeficit,thegoalis

basicallythesame:earnareturnoninvestment.Ratherthaninvestinginits own economy using capital from other nations, a nation running atradesurplusisattemptingtoinvest inanothernation’seconomyusingitsowncapital.Wouldyouexchangeyourgoodsorservicestosomeonewhotriedto

payyouwithfakemoney?Ofcoursenot,becauseit’sworthlessandyoucouldn’tuseitforanything—unlessthepersonpayingyouacceptedthesamemoneyinreturnfortheirowngoodsandservices.Thesamecanbesaid fornations.WhenNationAexportsgoods toNationB, it receivescurrency or some other form of ownership interest in the futureproduction potential of Nation B. Nation A believes this currencywillpurchaseanequalorgreateramountofgoods fromeitherNationBorsome other nation that intends to purchase goods and services fromNation B. Either way, the money that a nation with a trade deficitspendswilleventuallycomebacktoit.InthecaseoftheUnitedStatesandChina,Chinacurrentlyholdsone

ofthelargestreservesofU.S.dollarsintheworld.Chinahasalsobeenstrugglingtomanagepriceinflation,whileintheaftermathofthe2007financial collapse the United States has been experiencing pricedecreasesassociatedwitha strugglingeconomy.Aspricesbetween thetwonationsbegintobalanceout,thosecurrencyreserveswilleventuallycomebacktotheUnitedStates. Individualsandorganizations inChinawill find it cheaper to purchase an increasing number of goods andservices from the United States rather than to purchase themdomestically. The trade imbalance between these two nations willcontinue to decrease over time as each nation focuses on producing anarrower setofgoodsand serviceswithin their respectivecomparativeadvantages.

WhyYouShouldCare

A country can sustain a deficit as long as other nations see it as asuitable investment.A country can run a trade surplus so long as it isabletogenerateenoughdemandthatpeoplearewillingtotradecapital(such asmoney) to purchase the nation’s goods and services. The realthingweshouldconcernourselveswithisexactlywhatthepeopleandorganizationsofothernationsareinterestedinandwhetherourcountryisabletotakeadvantageoftheopportunitiesavailable.Anation can create a tradedeficit inorder topurchase the supplies

necessarytoimproveitsownproductionpotentialandproducegoodsinvalue fargreater than itwillhave to sellwhenothernationspurchasegoodsfromit.Thiswillcreatenetvalueusingcomparativeadvantage.Anationcancreateatradesurplusinordertoacquireownershipinoneormore nations that it hopes will increase in value through improvedproductionpotential,exchangerate,andreturnsoninvestment.

24.FACTORPRICEEQUALIZATION

Two nations that are economically integrated (meaning theirgovernments have eliminated many barriers to trade and work tofacilitate tradebetweennations)and thathavea significantamountoftrade between them will experience something called factor priceequalization. Put simply, this means that the longer they trade freelywith each other, the more pricing differentials between them willdecrease.Thisisadirectoutgrowthoftrade.Iftwonationscanproduceagood

of comparable quality (say, an automobile), but one is cheaper thananother, clearly the people of both nations will want to purchase thecheaper automobile. This forces the companies in themore expensivenation to either lower prices or go out of business. The other nation’scompaniescanincreasetheirpricestomeettheproductiondemandsofordersfornewautomobiles.Let’s expand that scenario beyond trade in a single good. Now that

somepeoplehavelosttheirjobsinNationAbecauseNationB’scarsaremorecompetitive,theworkersofNationAdecreasetheirownspending

becauseoftheirlowerincome—they’vegotlesssotheyspendless.Theymust find new work in a sector in which their nation is morecompetitive on an international level (say, computers). Either way,prices for automobiles will come down in Nation A, either becausecompanies are using fewer workers to produce an equal amount ofgoods,orbecausethey’resimplyproducingfewergoods.InNationB,ordersforautomobilesareup.Becauseofthat,following

thelawofsupplyanddemand,carpriceswillstarttoincrease.InNationA, thesamething ishappeningwithcomputerprices—they’rerisingtomeet increased demand, while in Nation B (which isn’t as good atproducingcomputersas it isatmakingcars), thepriceofcomputers issinkinginordertostaycompetitive.Once pricing between the two nations reaches equilibrium (in other

words,they’rebothproducinggoodsatnearlyequalaveragepricelevels,tradingonlyinthosegoodswhereineachhasacomparativeadvantage)then the price increases and decreases resulting from factor priceequalizationwilleffectivelystop.The above example is theoretical. With the arguable exception of

NorthKorea,nonationintheworldtradeswithonlyoneothernation.Should either of the nations in the above example begin tradingwithanothernation,NationC, thathas lowerpricesthaneitherof themforeithercarsorcomputers,theywillexperienceadditionalbenefitsastheyacquire more goods at much lower prices, improving efficiency innational resource usage, decreasing costs and prices of their ownproduction,andsoforth. Itcanbecomeverycomplicatedveryquickly,but only due to the large volume of trade between many differentnations;thesamebasicprinciplesholdconsistent.

WhatYouShouldKnowFactorprice equalizationoccurs as a result of competition.Abagof

rice, regardless of where it’s produced in the world, will require thesame factors of production: land, water, fertilizer, seeds, labor, andwhatever else goes into growing rice. These factors, sometimesdesignatedasrawmaterialsandlabor,areaprimarydeterminantintheprice levels of a particular nation. As access to the resources in eachnationbecomesincreasinglyavailabletothoseofothernationsthrough

increased globalization, the costs of the factors of production tend toequalize, causing average price levels in each nation to resemble eachother by either increasing or decreasing. The general takeaway here,then,isthatinthelongruninternationaltradebenefitsyou,theconsumer.Factor price equalization, when first established as an economic

theoryintheearlytwentiethcentury,referredonlytonationsthatwerenext to each other, or at least near enough to each other so they hadequalaccesstothefactorsofproduction.Inthemodernera,however,asglobalization increases and nations increase the volume of trade anddegree of economic integration, this principle is influencing traderelationsbetweenevenverygeographicallydisparatenations.

WhyYouShouldCareIn projecting how future trade will change between nations, factor

priceequalizationplaysanimportantrole.Aseachcompanyattemptstoloweritsowncosts,itwilleventuallyacquireresourceseitherdirectlyorindirectly from a foreign nation with the lowest prices. With a bit ofindustryknowledgeandsomeeconomic savvy, it’spossible toestimatechangesincostsandpricingstrategies.If twocompaniesproducedifferentgoods,eachinadifferentnation,

andonenationhassignificantlyloweraveragepricelevels,thecompanythatworksinthenationwiththehigherpricelevelscanexpectitsgoodstobecomemorecompetitive in thenationwith lowerprice levels.Theabilitytopredictsuchmovementsinimportandexportlevelsasaresultofpricechangesisimportantinunderstandingwhattoexpectfromyourcompany’sfuturecompetitivenessonaninternationalscale.

25.MERCANTILISM

For centuries, thedominant economic theorywasmercantilism. ItwasparticularlyinfluentialintheseventeenthandeighteenthcenturiesuntilitwasunderminedbyAdamSmithinhisbookTheWealthofNations.Mercantilismargues that the factorsofproductionare fixedandthat

for a nation to increase in wealth, it must do so at the cost of other

nations’ wealth. Mercantilists believed that a nation must maintain atradesurplus inorder toaccumulatewealth,and thatany tradedeficitdepletesthenation’stotalwealth.Moneywasrepresentativeonlyoftheamountofrawminerals,usuallygoldandsilver,anationpossessed.Inother words, a nation only had as much wealth as the volume ofpreciousmetalsitkeptinitspossession.Since gold, silver, and the currency based solely on them were the

preferredmethodsofpayingforgoodsintheseventeenthandeighteenthcenturies, even through trade, it stands to reason that those nationsrunning trade deficits would deplete their resources. This wasparticularlythecasesincemuchoftheperiodwasmarkedbywarsthatwere often waged by mercenary troops, who were paid using thenational reserves of gold and silver. As a result, the coffers of manynationswerequitefrequentlyempty.The logic of this economic philosophy drove nations inwarswaged

simply toobtainanother country’s assets; it also frequently resulted inrebellions by the mercenaries when the government was unwilling orunabletopaythem.

WhatYouShouldKnowTodaywecanseetheweaknessesofmercantilisttheory,asexpressed

by figures such as Jean-Baptiste Colbert (1619–1683), Louis XIV’sministeroffinance.Thebeliefthatanytradedeficitdepletesanation’swealthkeptsomenationsfromexperiencingthefullgainstoberealizedfromtrade.Nationalpoliciesthatmaintainedthegoldandsilversuppliesrequiredtobackupanycurrency(ortohaveavailablecurrencyatall)required nations to avoid exporting these preciousmetals. As a result,nations frequently did not take advantage of cheaper or better foreigngoods. Trade occurred on a more limited scale. Under a mercantilistphilosophy, it also becomes exceedingly difficult to align domesticeconomicpolicy thatbestbenefitsone’s countrywith the internationalneedsassociatedwiththatnation’stradeaswellasthemanagementofitscurrency.

WhyYouShouldCareSomewhat surprisingly,mercantilism, or at least remnants of it, has

survivedintothemodernera.Asmallbutveryvocalpopulationcallsfora metal-centric economic policy to be reinstated, despite its obviousshortcomings.It’snot as ifwe’venot tried this stuffbefore.Thegold standard, forinstance, was a system by which currency was freely and readilyexchanged for a fixed amount of gold (discussed more in Chapter 4),requiring a nation tomaintainminimum levels of gold. This system isonce again growing in popularity among economics undergraduatestudentsandsomefringeeconomistsandpoliticians.Thereality,though,isthat,aswithallformsofmercantilism,itisimpossibletomaintaininthe twenty-first century just as was the case in the eighteenth,nineteenth, and twentieth centuries and before for the very samereasons: Mercantilism has an adverse effect on trade, which moderneconomiescannotafford.TheUnitedStatesformallywentoffthegoldstandardin1971duringthe Nixon administration and it seems unlikely to come back. Whilemercantilism shouldn’t affect you directly—assuming that people haveenoughsensetoavoidimplementingsuchasystemagain—it’sextremelyimportanttobeawareofhowitworks.

CHAPTER4Currency

Despitebeinglabeledasoneofthemostvillainousandmalignantideasever devised, money plays a very important role in the lives of mostpeople.Even thosewhohate itprobablywouldn’t freelydispensewiththeirownsavingsandincome.Therealityisabitlessdramatic.Moneyisjustamethodforkeeping

trackofdebtsowedforgoodsandservices.After all, if it couldn’t be exchanged for goods or services, money

would justbe littlebitsofpaperandmetalwithnopractical function.AdamSmith,oftenconsideredtobe the founderofmoderneconomics,noted the paradox of value: Water is among the most useful of allresourcesyetgold,whichisfarlessuseful,isconsideredtobeofhighervalue.It’spreciselybecausecurrencyhaslittleornointrinsicvaluethatitcanbeusedexclusivelyasanintermediaryofexchange.Howexactlydoesthiswork?Let’simaginethattwopeople(callthem

Sam and Janet)want to exchange goods or services. Sam has nothingJanetwants,butshehassomethingSamwants.Alternately,SamwantssomethingofJanet’s,buthedoesn’t intendtoreceiveallorpartofhisshareoftheexchangeimmediately.WhatSamandJanetbothneedisamethodoftrackingthevalueoftheseexchanges.Tomakethisabitmoreconcrete:Samwants$10worthofbreadfrom

Janet,thebaker.Heoffersher,inreturn,$10worthofwhateverservicehe has on hand (say, mowing lawns). Janet doesn’t want her lawnmown, though. So, instead ofmowing her lawn, Sam gives Janet $10worthofmoney.Janetcanusethe$10inmoneytopurchasesomethingelse fromRalph.Ralphnowowns that$10worthofmoney.HecomesbacktoSamwiththeexpectationthatSamwillfulfillhisobligationforthepurchaseofbreadbymowingRalph’slawn,eventhoughRalphhas

given Sam nothing (except the money). In a similar manner, perhapsJanetwantsher lawnmown,butnot rightaway.SheandSamuse the$10asamethodoftrackingthedebtSamowesJanet—atsomepointinthefuture,he’llmowherlawn.Thesearetheoriginalrootsofcurrency.It’snothingmorethanan“Iowe you” letter for goods and services. The underlying resources arewhat give currency its value, not somebelief thatmoney itself has aninherentvalueseparatefromwhatitcanbeusedtoredeem.Whatmakesmoneyso important is the fact thatnearlyallpeople inthe world recognize what it represents and are willing to exchangethingsofactualusefulnessforit.Thisisakeypoint,whichiswhyIkeepcomingbacktoit:Moneyinandofitselfisworthless.Itsvaluecomesfromwhatitrepresents.Intheinternationalarena,notallcurrenciesarerecognizedashavingthe same value. It’s central to keeping international trade flowingsmoothlythatpeopleagreeuponhowmuchdifferenttypesofcurrencyareworth,bothasameasureofunderlyinggoodsandservicesandasaway in which currencies can be exchanged for each other. This isdetermined by a number of factors, including the basic supply anddemand foracurrency, theunderlyingvalueof thegoodsandservicesthatacurrency’snationproduces,anddomesticeconomicpolicy.While the underlying nature of currency has not changed since itsoriginal inception, it’s now far more sophisticated. In the modern erathere are many types of currency, with differences ranging from theamount of goods that can be purchased per unit to howmuch of onecurrencycanbepurchasedwithanother.Thevaluations,exchanges,andmethodsofmanagingcurrencyhaveallbecomeveryinvolvedbutnotatalldifficulttounderstand.Learninghowcurrencyworkswillverymuchimprove your ability to manage your money. Particularly in theinternationalenvironment,whichincludessomeadditionalcomplexitiesthat provide the opportunity to benefit or the risk of harm, yourfinancial security depends on how well you understand the nature ofcurrencytransactions.

26.FIXEDEXCHANGERATES

An exchange rate is how much of one currency you can buy withanother.Forexample,atthetimeofthiswriting,oneU.S.dollarwillbuyexactly0.7641euros(whichwouldbewrittenasUSD1=EUR0.7641).The inverse value is EUR1 = USD1.3087. One unit of a particularcurrency will purchase a number of units (or a fraction of a unit) ofsomeothercurrency.Therearetwoprimarytypesofexchangerates.Theeasiestofthesetounderstand is the fixed exchange rate, also called a pegged exchangerate.Afixedexchangerateisoneinwhichthevalueofonecurrencyisexchangedatexactlythesamerateasanothercurrency,nomatterhowthisothercurrencyfluctuates.Forinstance,iftheMexicanpesoisfixedtotheU.S.dollarataone-to-onerate(whereMXN1=USD1),thennomatter how the U.S. dollar changes value compared to any othercurrency in the world, the exchange rate between the dollar and thepesowillremainthesame.TheimplicationofthisisthatiftheexchangerateoftheU.S.dollartotheBritishpoundgoesup10percent,thentheexchangeratebetweentheMexicanpesoandtheBritishpoundwillalsogoupby10percentbecauseoftheratefixbetweenthedollarandthepeso.Foracurrencytoadoptafixed-exchangerate-to-changevalue(thatis,forthevalueatwhichtheexchangerateisfixedtochange)theremustbeachangeinofficialgovernmentpolicy.Thishappensquitecommonlyamongfixedcurrencies.

WhatYouShouldKnowAnationtypicallychoosestofixitsexchangerateinordertostabilizeexchange rate fluctuations.Nationswith smaller economies often havetroublemanagingvolatilityinthevalueoftheirexchangeraterelativetoother nations, creating uncertainty that causes big problems in trade.Rather than risk economic troubles that could destabilize the entirenation’spoliticaland social infrastructure, the leadersof suchanationwill usually opt, instead, to just peg their exchange rate to a currencythatismorestable.Thisisparticularlythecasewithnationsthateitherrely on goods that have seasonal production cycles or have economiesthatlackdiversification.Exchange rates are rarely fixed to just a single currency. Usually a

fixed exchange rate is set at a value that is an average of severaldifferentcurrencies,calleda“basket.”Thesecurrenciesarechosenfromeitherthenation’s largesttradingpartnersorthoseeconomicallylargernationsthataregeographicallynearby.A country can also choose to peg its currency to commonly traded

commodities such as gold and platinum or it can use such preciousmetals as an element in its currency basket. In 2005, for example,China’s currency (the renminbi, RMB) was pegged at a value thatcombinestheaverageoftendifferentcurrencies.However,someofthecurrenciesinthisbasketareworthmoreintheaveragethanothers.Thisisaccomplishedbyusingwhatiscalledaweightedaverage.Ratherthanaddingupallthevaluesthendividingbythenumberofcurrenciesused,asinanormalaverage,aweightedaveragemultiplieseachvaluebythepercentageofthetotalthatthevaluerepresents.

WhyYouShouldCareManynationsaroundtheworldhavefixedcurrencies;someofthem,

such as China, are very large economic players. When an Americancompanybuyssomethingfromthesenationsorsellssomethingtothem,it matters whether the product or service is listed in the domestic orforeigncurrency.Anytimethatcapitalcrossesinternationalboundaries,eitherbywayofapurchase,investment,ortransfer,thereisaverygoodchancethatoneofthenationsinvolvedhasafixedcurrencyandanevenbetter chance that somewhere along the supply chain a nationwith afixed currency contributed to the value of the transfer in an indirectmanner. Since the rate at which these nations fix their currencies toanother currency influences how expensive their goods are to othernations, you must pay careful attention to the peg that these nationschoose.The exchange rate is also important if you’re planning any

internationaltravel.IfyouknowtheexchangeratebetweentheUnitedStates and Europe is something on the order of USD1 = EUR2, thismight be a good time to take that vacation to France you’ve beenplanning. After all, one of your American dollars will buy two eurosworthofFrenchwineandchocolate!The peg that a nation with a fixed exchange rate chooses doesn’t

changethepriceofthatnation’sgoodsinitsowncurrency—notdirectlyanyway, since something that sells at RMB100will always still sell atRMB100,whetherChina’spegtotheU.S.dollarissetat100percent(aone-to-one ratio) or 1,000 percent (a ten-to-one ratio). However, forthoseoutsideofChina,therateatwhichtheRMBispeggedtothedollarwilldeterminehowmuchof theirowncurrency theyhave tospendtoacquire each RMB, which makes the currency itself more or lessexpensive.TheresultforChina’sexportstotherestoftheworld,then,isthattheexportsthemselvesbecomemoreorlessexpensivedependingonwhichcurrenciesareusedtopurchase them.At thesametime, foreigngoodswillalsobemoreorlessexpensiveastheChinesepurchaseothercurrenciesusingtheRMB.Why should you care about nations with fixed currencies? Becausemorelikelythannotyou’veboughtgoodsorservicesfromanationthathasa fixedcurrency, and the rateatwhich they fix that currencywillhaveaninfluenceonyourownfinances.

27.DEVALUATIONANDREVALUATION

Just because a nation has a fixed exchange rate doesn’tmean that itsexchangeratecan’tbechanged.Theprocessbywhichafixedcurrencychangesvaluebyitself,withoutthevalueofthecurrencytowhichitispegged changing in equal proportion, is very simple but can eitherstrengthen the country’s economy or bring about a regionalizedeconomicapocalypse.A fixed exchange rate changes value when the government of thatnationdecidestochangethevalueatwhichthecurrencyisfixed.Let’ssaytheU.S.dollarandMexicanpesoareexchangedataone-to-oneratio(USD1=MXN1)becausetheMexicanpesoispeggedtotheU.S.dollar.The Mexican government wants to decrease the exchange rate of itscurrency;theyissueastatementthatonedollarnowequals,forexample,0.75 pesos. Such a change is called devaluation—the Mexicangovernment,whichhasafixedcurrency,haslowereditsexchangerate.TheU.S.dollarnowbuysfewerpesos.

The oppositemove,wherein a fixed currency increases its exchangerate,iscalledrevaluation.Usingthesamebasicexampleasbefore(whichwaschosenforitssimplicityratherthananysortofaccuracyregardingthe exchange rate or currency policy of the nations discussed), shouldtheMexican government decide that theywant to revalue the peg ontheir currency by 25 percent, from USD1 = MXN1, then the newexchangeratewouldbesettoUSD1=MXN1.25,usingMexicanfederaleconomicpolicyasthemechanismforthechange.

WhatYouShouldKnowTheabilitytomanagetherateatwhichafixedcurrencyisexchanged

is critical to maintaining economic stability. Nations will periodicallyalter their exchange rate in order to account for any changes to theireconomic growth. If a nation’s domestic prices go up or downsignificantly as a result of its level of growth and inflation, but thecountry’s exchange rate does not change, that will cause imports andexportstobeeitherartificiallyhighorlow.

Ifpricesgoup,thecountry’simportswillrise(becausepeoplearebuyingcheaperforeigngoods)anditsexportswillfall(becausepeopleinothercountriesdon’twanttobuymoreexpensivegoods).

Ifpricesgodown,thecountry’simportswillfall(becausenoonewantstobuyforeigngoodsthataremoreexpensivethandomesticones)andexportswillincrease(becauseitcostspeopleinothercountrieslessmoneytobuythemthanitdoestobuygoodsmadeintheirowncountries).

Theimportantthingtorememberhereiswhathappenswhenanationrevalues or devalues its currency, and what the influence will be oninternational capitalmovement. It is not a difficult thing to learn, buttherearecasesthroughouthistoryofnationsseverelymisunderstandingtheimplicationsoffixedexchangeratemanagement.In1991,ArgentinapeggeditscurrencytotheU.S.dollarataone-to-

oneratio;however, its inflationratewasmuchhigher than thatof theUnitedStatesduring the sameperiod.Even though theArgentinepesowas able to purchase far, far less than the dollar, the exchange rate

betweenthetwowasequal.TheresultwasthatArgentinahadsomeofthemostexpensiveexportsinalltheAmericas,makingthemextremelyuncompetitive in the internationalmarketplace.Theotherconsequencewas that imports from other nations were cheaper than domesticArgentinegoods, so imports increasedaswell.The lackofdemand forArgentinegoodscausedinflationtosteadilygrowforoveradecadeuntilitspeakof17.3percentin2003.Whatbroughtdownunemploymentandsavedtheeconomyfromtotaldevastation?Anumberofthings,butoneof themost importantwas a 2002 policy that devalued the ArgentinepesofromARS1=USD1toARS1.4=USD1,thenallowedtheARStofloat.Withintwomonthsofremovingthepegentirelyandallowingthepeso to float (floating currencies are discussed in the next topic), theARSwasexchangingatARS3.5=USD1.Argentineexportsfellinpriceandwerenowindemand,andunemploymentratesconsistentlydroppedagaintostillhighbutnowmanageablelevels.

WhyYouShouldCareOne of the most difficult predictions in international economics is

fluctuationsinexchangerates.Forcompaniesthathaveforeignbranchesor those that do extensive amounts of trade, such fluctuations inexchange rates can become either extremely expensive or extremelybeneficial. These companies do all they can to predict these exchangerate fluctuationsandmanagehowthey react to them.Thisalsoaffectsyou,theconsumer.You live in Thailand and plan to purchase a pumped-up Ferrari for

exactly1millioneuros(justgowithit;it’sanexample).Atthetimeyousignthecontract,thatequals40millionThaibaht,butonemonthlaterwhen you go to exchange your baht for euros, the Thai governmentdecidedtochangeitspeggedexchangeandnow1millioneurosisequalto50millionbaht.NoFerrariforyou!Even though fluctuations this large are not very common, they do

happen from time to time, and smaller fluctuations happen quitefrequently.Theinfluencethatsuchachangeinexchangeratehasonthepriceof importsandexports canalsocausepricesacross thenation toincrease. If the price of a nation’s imports increases as a result ofdevaluation, then the companies that import those goods and services

will have to charge higher prices to make up for the higher cost ofproduction.

28.FLOATINGEXCHANGERATES

The exchange rates of a floating currency are determined in a slightlydifferentmannerthanthoseoffixedcurrency.Insteadofbeingsetbyagovernment agency at a fixed rate of exchange with some othercurrency,a floatingexchangerate is setbyboth thepeople selling thecurrency and those buying the same currency. Thesemarket forces ofsupplyanddemandareconsideredtobetheprimarydeterminantsoftheratesbywhichfloatingcurrenciesexchange.Thatbeingsaid,thesupplyanddemandforafloatingcurrencycaneachbealteredusingdomesticfiscal policy (the policies that control taxation and governmentspending)andfiscalpolicy(thepoliciesthatcontrolthequantityofthemoneysupplyandinterestrates,thelatterofwhichareconsideredtobethepriceofmoney).Given that every nation with a floating currency influences itscurrency’s exchange rate, the idea of a fully floating currency is littlemorethantheory.Therealityisthattheclosestmostnationscometoapure float is something called a managed float, wherein the nationallowsitsexchangeratestobecontrolledbysupplyanddemand,butthegovernmenttakesstepstoinfluencesupplyanddemandforitscurrency.Foreign currency transactions for floating currencies happen in amannerquitesimilartothatbywhichinvestorsperformtradesinstock.There’sanaskingprice,whichisthepriceatwhichsomeoneiswillingtosellacertainamountofcurrencyforanother.Forinstance,supposethecheapest someone is willing to sell 100 British pounds (GBP100) inexchangeforCanadiandollarsisCAD200,inwhichcasetheaskingpriceof GBP1 is CAD2. There is also a bidding price, which is the highestamount that someone iswilling topurchasea currency for in termsofanother currency. Let’s say someone is willing to pay CAD150 forGBP100. That would mean the bid value for GBP1 is CAD1.5. Thedifferencebetweentheaskandthebidpricesiscalledthespread.Inthisexample, the spread isCAD0.5, since theask isCAD2.0and thebid is

CAD1.5. Inorder for the transaction to takeplace, either thebuyerorthe sellermust compromiseon theprice.Transactionsquite frequentlyoccurthroughanintermediarythatmakesitsprofitoffthespread.Suchexchangestypicallytakeplaceelectronicallyinlargequantities,but smaller quantities that aren’t significant enough to influenceexchangerateshappenquitefrequentlyaswell.Nexttimeyou’reintheinternationalterminalofyourfavoriteairport,takeacloselookaroundand you’ll find a booth for exchanging currency.Usually it’ll have thespotrateslistedonanelectronicbillboard(thespotrateistheexchangerate by which you can exchange currency immediately in a singletransaction; this is opposed to some other forms of transactions thatinclude future transfers of money). You walk up, give them yourcurrency, and tell them which currency you want in exchange. Theymaketheirmoneybytakingadvantageof thespread,offeringonlytheaskpriceforeachcurrencybecausetheyknowpeoplewillpayitforthesmalldenominationsofcurrencybeingexchanged.Bankswillsometimesdo this as well, although it can be difficult to find some of themoreobscureinternationalcurrenciesexceptinlargedenominationorders.

WhatYouShouldKnowDespitetheseemingsimplicityofwhatamountstoanauctionsystemfor foreign exchange transactions, the complexity of these floatingexchange rates is amplified when you consider the multitude ofinfluences that determine currency prices. Changes to a number ofindirect factors cause not only valid changes in the valuation but alsospeculativechangesmadebyinvestors.Theseinturnmakevariationsinforeign exchange rates among floating currencies extremely commonand,attimes,extremelyfast.Thesavinggraceisthat,asnoted,floatingcurrenciesalsotendtobeassociatedwithextremelystableeconomies,sothatthechangesthatoccurintheratebetweentwofloatingcurrencieswillbe so small that theyonlyamount toa significantvalue for thoseorganizationsexchanginginverylargequantities.Theprimarydeterminantofthevalueofanation’sfloatingcurrencyisthe value of that nation’s underlying production. The total value of anation’s economy, asmeasured by the value of its production (usuallyusing GDP, discussed in Chapter 10), is represented by the nation’s

money,andifthatnumberchanges,thevalueofafloatingcurrencyinthe foreign exchange market also changes. As people invest in thatnation’seconomybytradingtheirownnationalresourcesforashareofthe nation’s currency, they are investing in that nation’s futureproduction potential under the belief that the nation will produceenoughtogivethecurrencyvalueasaformofexchangeformoregoodsandservicesatalaterdate.There are a great number of other factors involved in determining

floating exchange rates. To summarize, you’re watching for anyeconomic changes thatwill influence the amount of currency that thepeopleofaparticularnationmightwant.Youcanexpectanythingthatwould increase exports to some nation to have an influence ondecreasing the exchange rate for that nation’s currency as your owncurrencyincreasesinvalue.

WhyYouShouldCareMost of the world’s economically largest nations use floating

currencies, and the majority of currencies in the world that areconsidered to be reserve currencies (those currencies that are held onreserveinlargequantitiesbyforeignnationsforuseasaverycommonlyacceptedordemandedcurrencyforglobaluse)arefloatingcurrencies.Ifyou’veeverengagedinanysortofinternationaltrade,thereisastronglikelihoodthatyou’vedonetradewithanationthatmaintainsafloatingexchangerate.As noted, exchange rates among floating currencies normally vary

only to a very small degree at any given point in time, typicallymeasuredtohundredthsofapercent,calledpips(percentageinpoints).That’s not to say that the rate changes are too small to influenceindividuals, however. If a company experiences a cost increaseassociated with higher exchange rates, that cost increase will oftentranslate into higher prices for people purchasing its products. Thereverse canbe said for lowerexchange rates, though. Itpays towatchfloating rates carefully and seehowchanges are reflected in consumerprices.

29.DEPRECIATIONANDAPPRECIATION

Rather thanbeingchangedbygovernmentaldirective, thechange inafloatingexchangerateisdeterminedbythemannerinwhichbuyersandsellers determine the current and estimated future values of thecurrency. Since this is different from the manner in which fixedexchange rates are altered, the changes in the value of a floatingcurrencyaregivenauniquelabel.Whenafloatingcurrencydecreasesinvalue relative to another currency, this is called depreciation.When afloating currency increases in value, requiring more of a foreigncurrency to purchase an equal quantity of the domestic currency, it’scalledappreciation.Notethatallcalculationsofexchangeratereflectacomparisonofonlytwotypesofcurrency.Sowhileafloatingcurrencymight appreciate against one currency, it could simultaneouslydepreciateagainstadifferentcurrency.For example,we can imagine the currency ofNationA appreciating

against the currency of Nation B as a result of Nation B experiencinghighlevelsofinflationcausedbyrecklesseconomicpolicies.Atthesametime,CurrencyAdepreciatesagainstCurrencyCasexportsfromNationC increase, forcing many in Nation A to demand greater volume ofCurrencyC.SeenfromthepointofviewofNationB, itscurrencyisdepreciating

against both currencies A and C due to lower trade volume and highinflation resulting from a tax on imports. Currency C, meanwhile,appreciatesagainstbothcurrenciesAandBbecauseofhigherdemandforNationC’sexports.Thereasonfortheincreaseddemand:Thepricesof Nation C’s nearest competitor, Nation B, have recently increaseddramaticallyasaresultoftariffsimposedbyC’sgovernment.Astheaboveexampleshows,floatingexchangeratesdonotchangein

absolute terms, only in relative terms—relative to the value of othercurrencies, the same as fixed exchange rates. Unlike fixed exchangerates, however, you only need to evaluate the economic and tradeconditionsofthetwonationsinquestion.

WhatYouShouldKnow

What types of things, exactly, influence the floating exchange rate,then? There are a number of internal and external factors. The mostimportant determinant is the value of the nation’s production thatunderliesthecurrency.Afterall,thevalueofafloatingcurrencyisonlymaintained by the nation’s ability to produce goods and services forwhich the currency can be exchanged. As a nation produces a greatervalueofgoodsand services for thequantityof currencyproduced, thecurrencywillbeworthmore,givenitsrelativeabilitytopurchasemorefor an equal quantity of currency. This ties in closely with nationalinflation,discussedinmoredetailintopic32.In addition, some of the following factors can influence the floating

exchangerate:

Higherinflationwillpushdownexchangeratestemporarilysincethecurrentquantityofcurrencyheldcanpurchasefewergoods.

Anydomesticfiscalormonetarypolicythataltersinflationandgrowthlevelswithinthenationwillhaveaninfluenceonfloatingexchangerates.

Speculativeinvestorswhobelievethatthecurrencywilleitherincreaseordecreaserelativetoanothercurrencycan,attimes,forcelargeenoughtransactionstoalteranexchangerate.

Politicalissuescaninfluencefloatingexchangerates.OPEC’sthreattostopusingtheU.S.dollarasareservecurrencycausedmanyspeculatorstopanicandselltheirdollars,pushingdownthevalueofthedollarrelativetotheeuro.

Floating exchange rates can also become either undervalued orovervalued.Notonlydopeopleoftennothaveperfectinformation,butoften having the proper information doesn’t always matter. Whetherpeopleareinvestingandexchangingbasedonimperfectdataorchangestotheeconomicconditions,therealityisthatfloatingexchangeratesareinaconstantstateoffluxthatdoesn’talwaysrepresentthetruevalueoftheexchange.Often,speculativeinvestorswillattempttofindthesedeviationsinthe

price and value of a currency and invest accordingly so as to increase

their own income. This process is called arbitrage. At other times,particularly for businesseswhose primary operation is not financial innature,thebestoptionistosimplyavoidtheriskasmuchaspossible.

WhyYouShouldCareRegardlessofwhetherthenewexchangeratefollowingafluctuationis

a fair rateornot, theverynatureof the ratechangingallows forbothopportunities and threats for those individuals and organizations thatmakeforeigncurrencytransactionsevenirregularly.Dependingonhowsavvy you are in foreign exchange transactions as well as anytransactionsthatinvolveforeignexchange(i.e.,imports/exports,capitalmovement between parent and subsidiary, etc.), you can generatesignificantearningsbasedpurelyonvariationsinforeignexchangerates.

30.PURCHASINGPOWERPARITY

Maybeyou’veheardsomeonementionhowcheapthecostoflivingisinanother country, or that prices are a lot higher in some other placehalfway around the world. That’s because not every currency has thesamepurchasingpower.If, using only one unit of your own currency you can purchase ten

unitsof someothercurrency,butprices in that foreignnationarealsoexactly ten timeshigher than inyournative land,youwilluseexactlythe same number of units of your own currency to purchase foreigngoods.Soundconfusing?Let’suseaquickexample.

Wecansee that someone fromIndiacoulduse100 Indian rupees inordertopurchasebeerintheirownnation.OrheorshecouldexchangethesamenumberofrupeestogetenoughJapaneseyentopurchasebeerinJapan—becausebeerinJapancoststentimeswhatitcostsinIndia.Purchasingpowermeanstheabilityofacurrencytobeexchangedfor

goods. Perhaps something you can buy for four dollars in the UnitedStatescosts320yeninJapan.TotheJapanese,320yenmaynotseem

anymoreexpensivethanfourdollarstosomeonefromtheUnitedStates,since the Japanese alsomakemore yen atwork than people from theUnitedStatesmakeindollars.Allthismeansisthatoneyendoesn’thavethe same amount of purchasing power as the dollar, so it takes a lotmore yen to purchase something than dollars. However, it’s notuncommon to walk around carrying several thousand yen since thatcomposesonlyasmallproportionofwhattheaveragepersonmakes(inthe sameway that four dollars is a very small proportion ofwhat theaverageAmericanmakes).We can apply the principles of purchasing power to even different

partsofthesamenation—theaverageincomeinNewYorkCityisalothigher than theaverage income inOmaha,Nebraska,but theprices inOmahaarealsoa lot lower, soeveryperson is spending lessmoney tomaintain a lifestyle that’s equal to or better than that of New York(although New Yorkers would probably strongly dispute that). That’sbecause the purchasing power of the dollar varies across geographiclocations.Whereas purchasing power measures the ability of a currency to

purchase goods, amoreusefulmeasure for determining the valueof acurrency on an international level is purchasing power parity.Purchasingpowerparity(PPP)istheabilityofonenation’scurrencytopurchasegoodsinadifferentnation.Inotherwords,thiscompareshowdifferentcurrencies function in thesamecountry, rather than trying tocompare different currencies in different countries. It’s expressed asfollows:PPP = Foreign Price using Foreign Currency/Domestic Price using

DomesticCurrencyHow does this work in practice? Say, PPP=AUD4.56/USD4.07=

1.12. So, the PPP between theAustralian dollar and theU.S. dollar isAUD1.12perUSD1.In other words, the U.S. dollar purchases slightly more than the

Australiandollar—about12percent.TheAUDhasaPPPof1.12,sinceittakes1.12AUDforeveryUSDtopurchasethesamegoods.

WhatYouShouldKnow

The difference between the exchange rate of the currency and theabilityofthatcurrencytopurchasegoodsmakesitseemasifthegoodsof one nation are relatively more expensive or cheaper for people ofothernations.Ifthecurrency’sexchangerateissignificantlygreaterthanthe currency’s PPP, then the currency is overvalued. This makes thatnation’s exports appearmore expensive sinceyouhave tousemoreofyourowncurrencytopurchaseenoughforeigncurrencytobuywhateverit is you’re trying to import. The flip side to this is that when acurrency’s exchange rate is significantly lower than its PPP, it isundervalued. This causes that nation’s exports to appear cheaper toforeigners since they have to exchange less of their own currency topurchasethosegoods.Let’stakealookatanexample:

CostofaburgerintheUnitedStates:USD4.07CostofaburgerinJapan:JPY320Exchangerate:JPY78.4=USD1

Usingtheinformationabove,wecanfigureoutthePPPbetweentheUnitedStates and Japan. Startwith the cost of aburger in theUnitedStates—wepay$4.07.Nowexchangethatvalueatthecurrentexchangerate,andyougetJPY319.Uh-oh!Youdon’thaveenoughJapaneseyentopurchaseaburgerinJapanbecausetheexchangerateisdifferentthanthePPP rate. In this case, Japan’s currency is overvalued compared tothedollarbecauseequivalentgoodscannotbepurchasedinJapanusingthecurrentexchangerate.Another way to look at it is that the U.S. dollar is undervaluedcompared to the yen; remember that exchange rates are all relativebetweentwocurrencies.(Inthesemetricsthelargerormoreprominentcurrencyisnormallycomparedagainstthelessercurrency.However,wecould make an exception if there is some reason to believe that thelargercurrencyisartificiallyhighorlowinvaluecomparedtoanother.)A very popular index formeasuring PPP andwhether a currency isover-or undervalued, titled the Big Mac Index, was developed by TheEconomistmagazine.Meanttobeabithumorous,theBigMacIndexliststhe price of a Big Mac from McDonald’s restaurants in each nation.Althoughit’susuallyrecommendedthatyouuseseveraldifferent types

ofpricestodetermineaveragepricedifferencesbetweennations,theBigMac Indexuses just the one, the price of a BigMac, to determine thepurchasingpowerparity foreachnation. If thedifference inpriceofaBigMacbetweentwonations,eachnationusingitsrespectivecurrency,is not fully accounted for by the exchange rate between the twocountries, then that currency is considered to be overvalued orundervalued.

WhyYouShouldCareThepurchasingpowerparitybetweentwonationsisoftenconsideredtobeaguidelinefortheexchangeratebetweenthesamenations.Thereare a number of cases throughout history where nations have beenaccused of keeping their exchange rate undervalued in order tomaketheir exports cheaper. People tend to have very strong feelings aboutthis,andsomegovernmentpoliciesarebasedonthebeliefthatasinglenation’s currency is either over-or undervalued. People who complainaboutsuchcurrencymanipulationarecorrect,inasense,butarelookingatfartooshortatimeframe.Recall fromChapter 1 the idea of gains from trade. The people andorganizations of each nation intentionally seek out other nations topurchasethoseresourcesthathavelowerprices.Thisoftenleadsthemtonationsthathavelessdevelopedeconomies.Thelowercostsoflaborinthesenationscanresult insignificantlyhigherpurchasingpowerparityfortheforeigncurrencyinthatnation.Doesthatmeanthatthe leadersof theexportingnationareguiltyofmanipulatingitsexchangeratetointentionallyundervalueitscurrency?Theycouldbe,butit’simpossibletosaybasedonjustthatinformation.It’sequallyimpossibletoassumethatexchangerateswillautomaticallyandimmediatelyadjust toensurethataveragepricesaroundtheworldare the same, as thiswould eliminate anyopportunity a nationhas totakeadvantageofanabsoluteadvantage.NowrecallfromChapter3,inthesectiondealingwithfactorpriceequalization,thatinthelongtermand with greater amounts of trade, prices in two nations will slowlychangetomoregreatlyresemblepricesintheother.Still, PPP plays an important role in estimating the value of acurrency. Between two nations that are already relatively stable and

havesignificanttradetogether,thedeviationofexchangerateandPPPwill bemuch smaller and adjustmentswill happenmore immediately.Between nations that have little or no trade with one another, or fornationsthathaverelativelylessstableeconomies,thesePPP-basedover-andundervaluationestimatesmaydomore to indicate theopportunityto take advantage of national trade advantages that may not adjustexchangeratesforyearsorevendecades.Inbothcases,PPPisausefultoolforestimatingmovementsbetweentheexchangeratesofnations.Aswithall things, theexact informationyou derive from PPP depends greatly on the context in which bothnationsareplaced,butinallcasesthereisopportunitytoeitherbenefitfromvariationsinexchangerateand/orvariationsintradeadvantages.

31.INTERESTRATES

Monetarypolicyreferstotwoprimarythings:

1. Changesinthesupplyofmoney

2. Changesinthepriceofmoney

Theformer is relativelyeasy tounderstand: If thegovernmentprintsmoremoney or decreases theminimum requirements that banksmustadhereto for thepercentageofmoneytheymustkeep inreserve, thenthemoneysupplyincreases. If thegovernmentincreasestheamountofmoney that banks must keep on hand (their reserve requirements) orprints less money than that which is destroyed during the normalactivitiesofdailywearandtear,thenthemoneysupplydecreases.The price of money, though, is a little different. Isn’t the price ofeverythingelsemeasuredinmoney?Howcanmoneyhaveaprice?Theanswerisbothsimpleandcomplex.Ithastodowithinterestrates.Whenevermoney is borrowed, itmust be paidbackwith a little bitadditional,calledinterest(Islamicbankinghandlesinterestinaslightlydifferentmannerbutwiththesameendresult).Thereareanumberofdifferent ways in which people and institutions borrowmoney. These

include credit cards, various types of mortgages, consumer loans forthingssuchascarsorfurniture,andloansforindividuals.Therearealsovarioustypesofbusinessloans;forinstance,bondsissuedbycompaniesorgovernments are a typeof loan.Even themoneyyouput intoyoursavings account at the bank is borrowed by the bank and issued topeopleintheformofothertypesofloans.Fortheprivilegeofdoingthis,thebankpaysyouaninterestrate(althoughit’slowerthantheinterestratestheyearnfromissuingother loans; this is theprimarywaybanksgenerateincome).Ontopofallthis,thereareinterestratesexclusivetoloansbetweenbanksandotherfinancialinstitutions.Therearefartoomanydifferentindividualinterestratestolisthere.While each can be individually controlled and has its own influence,which is important for more detailed analyses, our concern for themomentisanoveralllookatinterestrates.As interest rates increase, the amount of money that must be paidback for a loan also increases. As a result, economists say that wheninterestratesincrease,thepriceofmoneygoesup.Conversely,thepriceofmoney is said tohave loweredwhen interest ratesdecrease.Asyoumightguess,thisimpactsinternationaltradeandfinancing.

WhatYouShouldKnowMostofthetimewhenpeoplerefertointerestrates,theyaretalkingabout the rates for federal treasury investments, both long and shortterm, aswell as the rates charged on loans between banks. These areoftencalledindicatorrates,becausetheseratesofteninfluenceanumberofotherinterestratesandareagoodindicatorofhowinterestisgoingtobetreated.Nowthatwe’venarroweddownwhichinterestratestopaythemostattention to,what theheckdoyoudowith that information?Thebestthing you can dowith it, if your interest is in global economics, is tocompare rates between nations. In particular, there are two things towatch for: interest rate differentials between nations, and changes inthosedifferentials.Whentwonationshaveinterestratesthatdifferfromeachother,thedegree to which they differ is important. A nation that has higherinterestratesthanyourownisagreatplaceinwhichtoinvest,giventhe

relativelyhighreturnyou’llget(assumingexchangeratesdonotchangein the meantime). On the other hand, it’s poor for borrowing, sinceyou’d have to pay back a greater amount than you would borrowingfrom a domestic institution. As a result, a differential in interest rateswill cause the flow of international investments to shift, altering theamount of resources being allocated to economic growth in anyparticularnation.In addition, a differential in interest rates will change the amount

beingborrowedineachnation.Asaresult,theamountofconsumptionand investments funded through lending will change in each nation,altering the amount of purchases, including exports and imports,between the two nations. Simply put, when two nations have interestratesthatdifferfromoneanother,investmentswillgotothenationwiththe higher rate, while borrowing will come from the nation with thelowerrate.

WhyYouShouldCareSomethingassimpleaskeepingtrackofafewindicatorinterestrates

between twocountries canverymuchcontribute to the financialwell-being of both the company you work for and, by extension, you. It’spretty easy to see the benefits associated with investing in nations athigher rates of return and borrowing from nationswith lower interestrates. Although interest rates influence a number of other issues inglobaleconomics,thesewillbediscussedintopic33.

32.INFLATIONRATES

We’ve talked about purchasing power already in topic 30. Purchasingpower,you remember, is theabilityofacurrency tobeexchanged forgoodsandservices.Thepurchasingpowerofacurrencycanchange;therateatwhichitchangesiscalledinflation.Thetermdeflationisusedtodenote periods of negative inflation, a process by which purchasingpower actually increases. This manifests itself as price and wagefluctuations. If, over the course of one ormore years, overall averagepricesinanationincrease,thatmeansyouhavetospendmoremoneyto

purchaseanequivalentamountofgoods.Thisisinflation.Ofcourse,youmayhavereceivedawageincrease,sowhiletheprice

increasemayforceyoutospendmoremoneyitisnotnecessarilycostingyou a higher percentage of your total income. Still, each individualdollarcanbeexchangedforfewergoods,reducingthepurchasingpowerofthecurrency.Atrendintheoppositedirection,inwhicheachunitofacurrencycanpurchasemoregoods,iscalleddeflation.After2007,theUnited States and much of Europe experienced a period of deflationduringwhichpricesforhousingandanumberofothergoodsdecreased,allowing people to purchase a greater amount of goods for an equalamountofcurrency,oranequalamountofgoodsforlesscurrency.Thiswasgenerallygoodbecausemanypeoplelosttheirjobsforcingthemtolive on less income than theyhad previously done. (Note:Deflation isnotalwaysgood.Steadilyfallingpricesmayindicatethataneconomyisinrecession.)Inflation is calculated as an average. Say, for instance, that the

averagepriceofgoodsandservicesinyournationgoesup100percentover ten years. In that case, we would say that the average annualinflationrateinyournationhasbeen10percentoverthepasttenyears.Duringtimesofdeflation,ourinflationrateisnegative.Soiftheaverageprice of goods and services over a ten-year period decreases by 10percent,wecouldsayeitherthatthenationhasexperienceda1percentannualdeflationrate,ora–1percentannualinflationrate.It’sthesamething.There are three primary forms of inflation: monetary inflation, cost

push,anddemandpull.

1. Monetaryinflation.Thisiswhathappenswhenthegovernmentdistributesmoremoneythanthatwhichisrepresentativeoftotalnationaloutput.Itdoesthiseitherbyprintingmoremoney,throughareductioninrequiredbankreservesofcurrency,orthroughanalterationofinterestratesthatincreasesspendingbypeoplewhoholdlargesavingsreserves.Notonlydoesagreaterratioofdollarstooutputmeanthateachdollarhaslessunderlyingproductionvalue,butthatalsomeansthattradersandspeculatorswillpushdownthevalueofthecurrency,sincethetotalavailableamountof

currencywillberelativelyhighercomparedtotheamountofvolumeofcurrencydesired.Inaddition,morecurrencyincirculationmeansmorespending,whichincreasesdemandforgoods,particularlyconsumergoodsandshort-termproductiongoodsassociatedwithinvestments.Thisinturnforcescompaniestospendagreateramountincoststoproduceenoughgoodsforeveryonethatwantsthem.Somefringeeconomistsrefusetorecognizeanyformofinflationexceptmonetaryinflation.Theyarewrong.

2. CostPushinflation.Thisiswhathappenswhencostsofproductionincrease,forcingcompaniestoraisepricestostayprofitable.Sometimesit’stheresultofspendingmoretoincreaseproductionorspendingmoretomaintainproductionascostsofrawmaterialsrise.Thisoccursoftenintheinsuranceindustry:Aperson’sinsurancepriceincreasestoreflectthecostsoftheircoveragebecausetheymakemanyclaims.Thiskindofinflationalsooccursinthepriceofoil.Damagetooilproductionequipmentthatreducestheavailablequantitywillincreasepricesascompaniesattempttorecoverlostproductionpotentialaswellasrecoverfromthecostsofdamagedequipment.Increasedcostsandpricesforceworkerstodemandhigherwagesinordertocontinuepurchasinggoods,resultinginhigherlaborcosts.Somearguethatthiskindofinflationisonlypossibleifthegovernmentincreasesthemoneysupply,butthisignorestheprincipleofmonetaryvelocity(thatis,howfrequentlyasingleunitofcurrencyistradedfornewgoodsandservices),theroleoftrade,andtheuseofcreditandlendingtofundpurchases.Thegovernmentdoesnotneedtoprintmoremoneyifpeoplejustincuragreateramountofdebt.Aswesawduringthefinancialdownturnof2007,spiralingdebtcreateshugeproblemsifit’simproperlymanagedbyeitherborrowersorlenders.Inaddition,costpushinflationresultingfromincreasedcostsofimportsdoesnotrequireanyshiftinmoneysupplytocauseinflationarypressures,asthatwillbecausedbytheshiftintradeflowsandthetermsoftrade.

3. DemandPullinflation.Thistypeofinflationhappenswhenpeoplewanttopurchasemoregoodsthanareavailable.Inthese

circumstances,eitheracompanywillselltothepeoplewillingtopaythemost,orthecompanymustspendmoremoneytoincreaseitsproductioncapacity.Thiskindofinflationisverycommonduringperiodsofhigheconomicstrength(alsocalledaboomcycle).Sinceemploymentishigh,peopleearnandspendmoremoney,forcingcompaniestoexpandtheirproductionpotentialabovepreviouslevels.

Aswithcostpushinflation,demandpullinflationcanmanifestascostpushinflationinanationpurchasingtheexportsofthenationoriginallyexperiencingdemandpullinflation.Inotherwords,increasedcostsandpricesassociatedwithhighlevelsofdemandinanexportingnationwilltranslateintohighercostsfortheimportingnationwithoutrespectivelyhighdifferentialsofdemandoversupply,causingcostpushinflationtooccur(thiswillhaveasignificantinfluenceontradeinthelongrun,butin the short run this will cause inflationary market shocks). Neitherdemandpullnorcostpush inflationare inherentlyrelatedtomonetaryinflation,however.Any of the three forms of inflation can be reversed to form

deflationary pressures. Also note that policies designed to manageinflation and deflation are only able to apply pressure, not directlychangethedirectionofeconomicgrowthorinflation.

WhatYouShouldKnowSo far all this talk about inflation has been purely about domestic

economics.So,whatdoesanyofthishavetodowithglobaleconomicsandtrade?Theanswerissimple:everything!Let’s say for amoment that one nation experiences inflation but its

tradingpartnerdoesnot.Thevolumeanddirectionoftradewillshiftasaresultofinflation.IfthepriceofgoodsinCountryAincreases,thathasalimitedmeaningforthepeopleinthatcountrysincewagesarelikelytoincreasesomewhataswell(althoughusuallynotasmuchasprices).However, the wages of workers in Country B, Country A’s tradingpartner,willremainthesame,soiftheexchangeratebetweenthetwonationsdoesn’tchange, thenthepeopleofCountryBmustspendmoreof their own money to exchange for enough domestic currency to

purchasethegoods.Asaresult,inflationcausesthepriceofCountryA’sexports to rise, decreasing demand for these exports and increasingdemandeitherfromCountriesB,C,andD,orsimplyincreasingdomesticpurchasingratherthanrelyingonanyimportsatall.Ofcourse,therearetwoperspectives:HigherpricesforCountryAalsomeansmoreexportsforCountryB,asCountryAhastospendlessmoneyasaproportionofitsnationalaveragetoacquiregoodsfromoverseas.This is only a temporary effect, however, as exchange rates adjust.

Thistopicwillbediscussedingreaterdetailintopics33and34.It’s important to note that the amount of trade anation experiences

can also influence inflation. If a nation’s trade goes up, then the totalamountofdemandwithinthenationincreases.Ifthisaddeddemandfora nation’s goods begins to test the current production levels, this cancreate inflationary pressures. If the demand for a nation’s exportsdecreases,thenthiscaneaseinflationarypressures(although,ofcourse,it can also cause unemployment, if any company or industry reliedheavilyenoughonexports).

WhyYouShouldCareTheinfluencethatinflationhasontradeandviceversaplaysacritical

roleindeterminingbalanceofpaymentslevelsforanation.Thisinturncaninfluencetherolethatnotonlyanindividualcompanyhaswithinaglobal industry,butevenanentirenation. Ifyouoryouremployerdoany sort of business across international borders, it is especiallyimportantthatyoupayattentiontoinflationratesineachnationwhereyouhaveoperations.It’scriticalthatyouatleastunderstandyourownnation’sinflationandhowitchangescomparedtosomeofyournation’slargesttradingpartners.Inflation, in the media and in common public discourse, is always

treatedasabadthing.Aswithmosteconomicmatters,whereathreatiscreated, so too there is created an opportunity. The key lies inunderstandingtheimplicationsofinflationoneconomictransactionsandfinancing. Once you understandwhat inflation is, and how it impactstransactions,youcantakeadvantageoftheshiftsthatoccur.Applythisinformationoninflationtoyourownbusinesstransactionsbutbewary,as the impacts discussed here are temporary. Applied to international

investing, the influenceof inflationanddeflationarenodifferent thanwithdomesticinvesting.Youwantyourreturnsoninvestmenttoexceedannual inflation, or else that inflation will cause the value of yourinvestment to decrease relative to the prices in your nation. As withtransactions,however,aswe’llsee,theroleofinflationoninternationalinvestmentsbecomesabitmorecomplicated.

33.INTERNATIONALFISHEREFFECT

Bynowyoumighthaveguessedthatthereissomerelationshipbetweeninterest rates, inflation rates, and exchange rates, and that it allinfluencestradebetweennations.Thisrelationship,initssimplestform,iscalculatedusingtheInternationalFisherEffect(IFE).TheIFE,namedfor its formulator, the economist Irving Fisher, states that for every 1percentdifferential in interest ratesbetweennations, therewill bea1percentdifferentialintheoppositedirectionbetweentheexchangeratesofthesamenations.Forexample,ifVietnamincreasesitsinterestratesby5percentoverThailand,thentheThaibahtwillappreciateinvalueover the Vietnamese dong by 5 percent. While this is a simplifiedexample, iteffectivelyillustratestherelationshipbetweeninterestratesandexchangerates.TheIFEusesinflationasamechanismforturningchangesininterest

ratesintochangesinexchangerates.Asinterestratesincrease,inflationincreases as well, since the increase in interest rates causes cost pushinflationtooccurasaresultoftheincreasedcostofborrowingmoney.Whenthisinflationincreases,thentheexchangerateofthatnationoveranother must decrease, in order to correct for the differential ofpurchasingpowerparityofthecurrencyandthepreviousexchangerate,allowing for thatnation’sexports to retainanequilibriumpriceon theinternationalmarket. If that’sabitmuchtofollow,here’satheoreticalexample.BelizeandUruguay,tradepartners,havetheexactsameinterestrate

of 10 percent, the exact same inflation rate of 10 percent, and anexchange rate at BZD1 = UYU1 (BZD = Belizean dollar; UYU =Uruguayan peso). One day on a clearmorning in spring, the Belizean

government decides to raise interest rates by 1 percent. They think itwill be simple, but lo! they start a series of events that alter theeconomiesof bothnations.Now thatBelizehas an11percent interestratewhileUruguaystillhasa10percentinterestrate,theinflationrateinBelizealsogoesupto11percent!Thatinturncausestheirexchangerate to decrease to BZD0.99 = UYU1! By the time the Belizeangovernment realizes what’s happening, their exports to Uruguay havealready increased significantly because the people of the land ofUruguay can now purchase so much more with the same amount ofUYU!…orcanthey?The reality is that the relationship between interest rates and

exchangeratesisnotsoeasytocontrol.Asofthiswriting,nooneknowshow strong a reaction in exchange rate will occur in response to achange in interest rates. Therehavebeen instanceswhere therewas areactiongreaterthanone-to-one(theratioIusedintheexampleabove),andtherehavebeeninstancesthatyieldedlessthanaone-to-oneratio.

WhatYouShouldKnowPartof theconfusingnatureof the InternationalFisherEffect is that

the influence it has changes over time. Interest rates don’t necessarilychange and then immediately change back. The differential of interestrates between two nations continues, and since exchange rates areconstantly changing relative to each other (except for those that arepegged toeachother),whatweendupwith isa reaction inexchangeratesthatiscontinuouslyrespondingtovariationsininflationandtradethat result fromthechange in interest rates.This reaction toexchangeratesfollowsacommonlyseenpatternineconomicscalledaJ-curve.A J-curve is so called because—wait for it!—it’s a curve on a graph

that looks likeaJ.What thismeans forexchange rates is thatwhenanation’sinterestratesriserelativetoanothernation’s,itsexchangeratedoes, in fact, decrease for a timebut then it increasespast its startingpoint.Thishappensbecausethedevaluedforeignexchangerateattractsmoretrade,forcingtheexchangeratebackupoveranextendedperiodoftime,assumingthattheconditionsoftrademeettheMarshall-Lernercondition(discussedintopic34).

WhyYouShouldCareGlobal economics includes a number of chain reactions where a

seeminglyinnocuousbitofeconomicpolicycausesanindirectimpactonanumberofthingsthatthepolicymakerhadneverimaginedwouldhaveeverbeenpossible.TheInternationalFisherEffectisoneofthosechainreactions of interlinking economic influences. What’s really amazingabout the IFE is that, although still unrefined, it starts with apremeditated,predictableactiontakendeliberatelybyamemberofthefederalgovernment.Fromthatpointon,youjusthavetoanticipatethedifferentstepsinthechainreactioninordertobenefitfromtheprocessbywhichitallhappens.

34.MARSHALL-LERNERCONDITION

Oneof themostbasic ideas ineconomics ispriceup,demanddown—thatis,thebeliefthatasthepriceofaproductgoesup,thequantityofthatproductthatpeoplewillbuygoesdown.Whilethereareexceptionsto this rule, generally itholds true.Thenext step is todeterminehowmuch a change in price affects demand. This is determined using acalculationknownasthepriceelasticityofdemand(PED).Thisdividesthepercentchangeinthequantityofunitssoldbythepercentchangeintheprice.APEDof1wouldmeanthata1percent increase inprice iscorrelatedwitha1percentdecreaseinunitsales;greaterthan1meansthat unit sales would drop by more than 1 percent, and less than 1meansthatunitsaleswoulddropbylessthan1percent.TheMarshall-Lerner condition (named forAlfredMarshall andAbba

Lerner) applies this idea of price elasticity to the relative increase inpriceresultingfromchangesinexchangerate.Itdoesthisbycomparingthesechangestofluctuationsinthebalanceoftradesthatresult.Recall that when Nation A’s exchange rate depreciates relative to

other nations, then Nation A’s exports are cheaper for other nationswhileimportsintoNationAbecomemoreexpensive.Asaresult,we’relooking at two separate PED calculations: one for exports and one forimports.

1. ExportPED:Percentchangeinthequantityofdomesticgoodsdemandedbyforeignnationsdividedbythepricechangecausedbyexchangeratefluctuations.Asanation’sexchangeratedepreciates,theamountofdomesticexportspurchasedbyforeignerswillincreaseasaresultofthelowerpricesusingforeigncurrency.

2. ImportPED:Percentchangeinthequantityofforeigngoodsdemandeddomesticallydividedbythepricechangecausedbyexchangeratefluctuations.Asanation’sexchangeratedepreciates,theamountofforeignimportspurchasedbylocalswilldecreaseasaresultofthehigherpricesusingdomesticcurrencytopurchaseforeigngoods.

Nowaddthetwovaluestogether.Iftheyequal1orgreater,thentheimpact will be an increase in the nation’s exports and a decrease inimports, causing a positive shift in the nation’s current account and anegativeshift inthecapitalaccount(i.e., thiswilleither lessenatradedeficitorincreaseatradesurplus).Ifthetotalislessthan1,theneitherdemand for the nation’s exports won’t increase enough, or domesticdemand for foreign imports won’t decrease enough to reverse a tradedeficit.Evenifthetotalis lessthan1,demandforimportsandexportswill still change (assuming the total is greater than 0), but this won’tcreatethepositiveshiftinthecurrentaccountbecausethedifferentialinthe quantity of trade income needs to exceed the depreciation in thevalueofthetradeincome.

WhatYouShouldKnowAtfirstdepreciationinvalueofanation’scurrencycauseslittlemore

to happen than a shift in the value of imports or exports, withoutactuallychanging theirquantity.Thereason for this is that itcan taketime for individualsandorganizations tochange their spendinghabits,develop new contracts, and otherwise alter expenditures and sales toreact to the shift in exchange rate. It is for this reason that, like theInternationalFisherEffect,theMarshall-LernerconditiontendstofollowaJ-curve.The Marshall-Lerner condition influences the International Fisher

Effectiftherequirementsfortheconditionaremet(thesumofthePED

for imports and PED for exports is equal to or greater than 1). Undersuchacircumstanceandtheimpactonexchangeratesthatachangeininterest rates has as a result of the inflationary mechanism, thoseexchange rateswill increaseagainover the long run.Thiswillbeasaresultoftheshiftofthebalanceofpaymentsandtheunderlyingincreasein demand for the nation’s exports as well as a decrease in thedistributionofitscurrencyinternationally.

WhyYouShouldCareAchangeincurrencyexchangeratesbetweentwonationschangesthevalue of business exchanges, but that is neither cause to panic norcelebrate. If your currency appreciates compared to a trading partner,youcangetyoursuppliescheaper,andifyourcurrencydepreciates,thethings you purchase from overseas will be more expensive. This allhappensonlyintheshortterm,though,asthebusinessesinbothnationsworktoadjusttheirpurchasesandsalesinresponsetothechange.Once you understand that a change in the value of your country’scurrencydoesn’talwaysaffectitsbalanceofpayments,youcanusetheMarshall-Lerner condition to determine in the long termhow you andyourcompanyshouldreacttoachangeinexchangerates.Decidehowitwillinfluencedemandforyourproduct,understandhowitwillinfluenceyour demand for foreign imports, and properly prepare your pricingstrategies, output, and even how best to allocate your assetsgeographically to take the most advantage of the shift in value. Forinstance,ifyouhavefinancialassetsorinvestmentsinonenation,thenthe change in exchange rate will first change the value of the assetsrelative to your own currency’s rate, but that may change thecompetitiveness,totalproduction,orevenjustthetotalvolumeoftradeandresourceflowstoinfluenceyourassetsinwaysyouotherwisewouldnothaveexpected.

35.OTHEREXCHANGERATEDETERMINANTS

Thereareawidevarietyofthingsthatdeterminethesupplyanddemandforcurrenciesthat, inturn,determineexchangerates.Anumberofthe

most influential oneshavealreadybeendiscussed:nationalproductionlevels, interest rates, inflation rates, balance of trades levels, terms oftrade,andpurchasingpowerparity.Stillthereareotherstobeexplored.Some of them cause temporary fluctuations, while others may causepermanentchanges.Permanentchangestotheexchangerateofacurrencyarethosethatsignificantly alter the value of the currency as a form of trade. Thatdoesn’t necessarily mean that the value of the currency itself haschanged,butitsabilitytobetradedhassomehowchangedbythenatureof the currency’s usage. In contrast, those influences on exchange ratethat are temporary innaturedon’t change theunderlying valueof thecurrency,nordotheyevensignificantlychangethelong-termsupplyordemandforcurrency.

WhatYouShouldKnowTheissueofpublicdebt influencesexchangeratesbuteventhemostvocal of opponents of government spending and debt seem to havedifficultyvocalizingthereasonforthis.Here’sabasicexplanation.Governmentsincurdebtbyissuingtreasurybondsandtreasurynotes,meaning that the majority of government debt is held by privateinvestors.Asthegovernmentspendsmoreborrowedmoney,acoupleofthings happen. First, the actual demand for U.S. funds throughgovernment spending decreases relative to the supply, requiring thegovernment to spendmoremoney to attractmore private contractors.Second, the bad press associated with “record government debt”alienates investors, requiring the government to push up interest rateson the debt in order to attract investors. Recall from our earlierdiscussions that interest rateshave a significant influenceon exchangerates,whichiswhatcausestherelationshipbetweendebtandexchangeratesbetweennations.Speculative investors are also a determinant of exchange rate.Unfortunately, speculation is easily the most difficult influence onexchangerates topredict.Sometimesspeculatorsseemlike littleyappydogs, barkingwhen thewind blows thewrongway.Unfortunatelywedon’thavetheopportunityheretodelve intobehavioraleconomics,solet’ssummarizeabit.

Peopleareirrational;theirfinancialdecisionstendtochangebasedontheirmoodat the time, thenewsof theday,and thepotentialgainorloss (as opposed to the likely gain or loss). They participate in herdbehavior(allofthemtendtostart“running”inthesamedirectionbasedon nothing more than seeing others running). This all warrants a lotmore explanation, but let’s reduce it to sayingmerely that people areunstable,andthatinstabilitycontributestosmall,temporaryfluctuationsinexchangerates.Speakingofbehavioralinstability,let’stalkaboutconfidence!Muchoftheinherentvaluethatwe,aspeople,placeoncurrencycomesfromourconfidencethatwewillbeabletoexchangeitforgoodsandservicesatalaterdate.Withoutthatconfidence,acurrencyisworthless.Nothing harms public confidence in a currency more than politicalinstability. People begin asking whether the current government thatbacksthecurrencywillexistforlong,whetheranynewgovernmentwillsupport the currency, or whether policies that influence inflation andexchange rates will see dramatic changes. On the other hand,governmentsthatareextremelystabletendtohavecurrencieswithnotonlyhigherexchangeratesbutalsolessvolatileexchangerates.The final, and probably most important, of the secondarydeterminantsofexchangerateisthestatusthatsomecurrenciesachieveasareservecurrency.Becomingareservecurrencyissortoflikebeingin an elite club; unfortunately,membership in that club comeswith acurse.Being a reserve currency means that demand for the currency goessky-highanditmaintainsstability.Reservecurrenciesarethosethatareconsideredtobeverystable,havelowrisk,havelowvolatility,composea significant percentage of total transaction value, and can be easilyexchangedorofferedinjustaboutanynation.At that point, some currencies are chosen to measure the value ofinternationally tradedcommodities,suchasoil.Fordecades,OPEChasusedtheU.S.dollartopriceoilexports;theresultisthatallnationsareexchanging their currency for U.S. dollars, or at least paying anequivalentpricetothemarketexchangerate.Governmentstendtoholdlargequantitiesofthesereservestomaketradingandexchangeeasyfor

awidevarietyofnations.Otherreservecurrenciesincludetheeuro,theJapaneseyen,andtheBritishpound.

WhyYouShouldCareSure, it’s importanttoknowhowexchangeratesaredetermined,butthese determinants are really just secondary compared to the moreinfluential ones. However, these secondary determinants give vitalinformationaboutthenatureofmoneyandtherolethatpeoplegiveitintheirlives.

36.THEGOLDSTANDARD

Goldhasbeenusedformillenniaasacurrency,meltedandthenmoldedto form currency by nations across eastern Europe andmuch of Asia.One of the many roles that gold plays today is as a currency with afloatingexchangerate.Prior to the nineteenth century, the dominant monetary form inwesternEuropehadbeenthesilverstandard.Theapplicationofaformalrateofexchangebetweengoldcurrenciesbeganin1717.IsaacNewton(whowas running the royalmint of theUnited Kingdom at the time)overvaluedgoldintermsofsilver,causingadrainofsilverintheregionaspeopleexchangedforgoldinternationally.Bythe1790s,thesituationhad reached crisis proportions; to correct the problem Britainimplementedtheinternationalgoldexchangesystemin1819.The reason for this short history lesson is to show you exactly howlong the ideaof a gold standardor silver standardhas existed.By thetwentieth century, we fixed some of the problems with currency byallowingnationalproduction todetermineexchange(theoriginal rootsof theuseofcurrency) rather than toarbitrarilypegcurrency to somepreciousmetal.Despitethis,therearepeoplewhowanttoreinstitutethegoldstandard.At any point in this book where the gold standard is mentioned,understandthatalthoughthedatesofimplementationandpopularityofeithergoldorsilvermaydiffer,theiractualfunctionalitydidnot.Forthe

purposesofunderstanding international transactions Iwill be referringexclusively to the gold standard, but the two terms can be usedinterchangeably.

WhatYouShouldKnowAgoldstandardisamethodofeconomicandmonetaryregulationthatpegs the value of a nation’s currency to a fixed amount of gold andrestrictsthequantityofanation’scurrencytotheamountofgoldithasinitsreserves.Oftenthisisaccompaniedbyafreeexchangeofcurrencyandgoldbythegovernmentfordomesticuse,thoughtheexportofgoldwas often discouraged throughout history, given that nations wererequired to maintain extremely high reserves of gold in order toeffectively withstand the volatility associated with the supply anddemand for currenciesworldwide. This, of course, causes a conflict ofrolesforgold.Whether you’re talking about gold or silver, all these differentmeasures of value are just new ways of saying the same thing:mercantilism(seetopic25).Don’t lettheexistenceofapapercurrencyfool you—as long as that currency is strictly pegged in value andquantitytothenation’ssupplyofgold,itmightaswelljustbeusingthegolddirectly.Thenationcouldhavejustaseasilydeterminedthatmud, insteadofgold,shouldbetheunitofvalueunderlyinganation’scurrencyandtheresultwouldhavebeenthesame.Nationalwealthunderagoldstandardisbasednotonthenation’sabilitytoproducesomethingofvalue,butonhowmuch of some naturally occurring substance can be accumulated.Putsimply,limitinganation’smonetarypolicybystrictlytyingittotheamountofgoldthatanationholdsrestrictstheabilityofthatnationtoproperlymanageitseconomy.In addition to limiting economic growth, the gold standard severelyexaggerates recessions (an inability by the Federal Reserve to useexpansionarymonetary policywas amajor contributor to the severityanddurationoftheGreatDepression)andcausesshort-termpriceshocksassociated with the inevitable changes in the peg or discovery ofadditionalgold,andthat’salljustthedomesticharm.Internationally,thegoldstandardsuffersfromthesamebasicproblem

that the U.S. dollar suffered from during the early twentieth centurywhena largenumberof theworld’sdevelopedeconomiespeggedtheircurrenciestoit,aproblemreferredtoastheTriffinDilemma(namedfortheeconomistRobertTriffin).This states thatwhenanation’sprimarycurrencyalsoactsasaninternationalreservecurrency,thereisaconflictbetweentherolesthatthecurrencyplays.Whilethisisusuallyreservedfor currencies, remember that under the gold standard, gold is thecurrency of choice for many nations, which leaves each of themincapableofproperlymanagingtheirowneconomy.Forcenturies,governmentswouldgotowarwitheachotherinorderto collect more precious metals, seeing any trade deficit as a loss ofnationalwealth. (Thiswas also themotivation for Spanish voyages toCentralAmerica in the sixteenth century; theywere in search of largesupplies of gold and silver.) It became illegal in many places to payforeignerswithgoldorsilver,andmanygovernmentsattemptedtostopallformsofinternationaltrade.DuringtheattemptofWesternnations to implementagoldstandardin the 1800s, all exchange rates were pegged to gold, so when pricelevelsaroundthenationchanged,theyallchangedtogether.Thiscausedhavoconthebalancesofpaymentsbetweennations,andkeptanynationfromobtainingitsfullpotentialgainsfromtrade.Basing thewealthofanationongoldalsocreateswealthdisparitiesbasedonnothingofvalue.Goldisexpensiveanddifficulttoprocess,andnot all nations are provided with the same reserves of gold. Under afloatingrate,ascurrentlyused,alargeincreaseinthesupplyofgoldwillautomaticallydecreasegold’sprice,butunderagoldstandardthatgoldis representative of the nation’s total wealth. As a result, if aninternationalgoldstandardwereimplemented,Australiawouldprobablyend up the richest nation in theworld since it has the largest naturalgold reserves. Not that there’s anything wrong with Australia—exceptthat their total production potential is much lower than many othernations.MiltonFriedman,aNobelPrize–winningeconomist,estimatedthatthecostofmaintainingapropergoldsupplywouldbe2.5percentofGNP.For theUnitedStates, thatwouldhavebeen$300billion in2005.Fornations without proper access to their own gold supply, trade would

become exceedingly difficult, and even developed nations would havedifficultybenefitingfromtradewiththesenations.

WhyYouShouldCareThe gold standard has been rejected on a global level, by everymodernnation in existence, for a reason.While it’s easy to seewhy itmight be attractive, as it is extremely simple to understand and isusuallyassociatedwithlowlong-terminflationrates,thesearereallytheonly two benefits. As noted, those low long-term inflation rates arejoinedbyextreme short-termpricevolatility, including largeeconomicshocks. The gold standard is also associated with extremely highunemploymentandsloweconomicgrowthsincenationsareincapableofperformingthemonetarychangesrequiredtorecoverfromarecessioninanysortoftimelymanner.Asfarassimplicitygoes,asyou’veprobablyguessedbynow,“simple”economicsolutionsareoftenwrong.Thethreatsassociatedwithmercantilistdescendantssuchasthegoldstandard are global in nature. There is not merely collateral damagewhenonenationfails,butmultiplenationsaredirectlyaffected.NobelPrize–winning economist Paul Krugman said it best in his article forSlate, “TheGoldBugVariations”: “The currentworldmonetary systemassignsnospecialroletogold;indeed,theFederalReserveisnotobligedtotiethedollartoanything.Itcanprintasmuchoraslittlemoneyasitdeems appropriate. There are powerful advantages to such anunconstrainedsystem.Aboveall,theFedisfreetorespondtoactualorthreatenedrecessionsbypumpinginmoney.Totakeonlyoneexample,that flexibility is the reason the stock market crash of 1987—whichstarted out every bit as frightening as that of 1929—did not cause aslumpintherealeconomy.”TheGreatDepressionofthe1930sandtheLongRecessionofthe1870swerebothcaused,inverylargepart,bythegold standards of their respective times. Avoiding this in the futureshouldbeatoppriorityforanyonewithasenseofself-preservation.

37.SPECIALDRAWINGRIGHTS

Whengovernmentsthemselveswanttoexchangecurrency,theyusethe

InternationalMonetary Fund; or at least those 188nations (out of theestimated196nationsintheworld)whoaremembersoftheIMFdoso.Whengovernmentsexchangecurrency,it’sneverinsmallquantities,sothere are some special methods by which this happens. Each uses aspecial type of currency, available only to governments, called SpecialDrawingRights(SDRs).AlthoughSDRsaren’t technicallyacurrency, itcan be helpful to think of themas a special type of currency that hasverystringentlimitationsonhowitcanbeused.SDRscanbeheldbyanymembernation,thenusedfreelyinexchangefor thecurrenciesofothermembernations.Currently, thevalueof theSDR is set by the average of four currencies: the U.S. dollar, theJapanese yen, the euro, and the British pound. Although the value ofSDRs changes as frequently as the four currencies that compose thevaluationbasket, thebasket itself isevaluatedandseteveryfiveyears.Inotherwords, even though thepeg is evaluatedevery fiveyears, thecurrenciestowhichSDRsarepeggedcontinuetofloat,causingvaluationfluctuations. As with any pegged currency, the peg itself must bechecked periodically to ensure that fluctuations in the value of thecurrenciestowhichtheSDRispeggeddonotcauseseveredisparitiesinthemarketvalueofthecurrencyandthepeggedvalue.SDRsareclaimsagainstreservecurrencyheldeitherbytheIMForitsmembernation.Thisworksintwoways.

1. AnationcanpurchaseSDRsandusethemtoexchangeforthemarketvalueofothercurrencies.

2. IfanationdoesnothaveenoughreservecurrencytomeettherequestsofthenationattemptingtoexchangeitsSDRs,theIMF,whichisgiventheauthoritybyitsmembernationstoensurethatothernationshavereservesofthecurrencybeingsoughtinsufficientquantitysoasnottoputthatnationatriskofhavingshortages,willexchangeitsreservesforSDRsinordertofulfilltheneedsofthosenationsthatarealreadyexperiencingshortages.

Neitherof these transactionssignificantlyalters the totalwealthofanation;theyaremerelyusedasamethodoffacilitatingtradeandotherfinancial transactions between nations. The IMF maintains reserve

currenciesprimarilyby sellingSDRsaswellasbycharging interestonloans. The exchange of these currencies for SDRs helps to coordinatetradeandcurrencyexchangesbetweennationstopromoteinternationaltradeandeconomicgrowth.

WhatYouShouldKnowThe IMF itself acknowledges that the current role of the SDR isinsignificant in global trade.While the IMF attempts to point out thatincreasing the role of the SDR could significantly benefit global tradeandIMFmembernations,eventhosewithverylargecurrencyreserves,that isnotthecurrentrealityfortheSDR,sowe’renotgoingtoworryaboutspeculating.What’sreallyimportanttoknowabouttheSDRisthepurposeforwhichitwasoriginallycreatedandtheroleitwasmeanttofulfill.AccordingtotheIMFwebsite,

“TheSDRwascreatedbytheIMFin1969tosupporttheBrettonWoods fixed exchange rate system.A country participating in thissystem needed official reserves—government or central bankholdingsofgoldandwidelyacceptedforeigncurrencies—thatcouldbe used to purchase the domestic currency in foreign exchangemarkets, as required to maintain its exchange rate. But theinternational supply of two key reserve assets—gold and the U.S.dollar—proved inadequate for supporting the expansion of worldtrade and financial development thatwas taking place. Therefore,the internationalcommunitydecided tocreateanew internationalreserve asset under the auspices of the IMF.However, only a fewyears later, the Bretton Woods system collapsed and the majorcurrencies shifted to a floating exchange rate regime. In addition,thegrowthininternationalcapitalmarketsfacilitatedborrowingbycreditworthygovernments.BothofthesedevelopmentslessenedtheneedforSDRs.”

Inotherwords,justasattemptsatimplementingagoldstandardfailedtosimultaneouslymeet theneedsof thedomesticeconomicpolicyandinternationaltrade,sodidtheuseoftheU.S.dollar,towhichjustabouteverymajorcurrencywaspeggedundertheBrettonWoodssystem.

WhyYouShouldCareSometimes it’shard to seeexactlyhowsomething that’s exclusive to

the federal governments of the world’s nations can influence, or beinfluenced by, the individual people of those nations. The realimportance,though,liesintherolethattheSDRcurrentlyplaysevenina world of floating exchange rates, which can’t be fulfilled by ourcurrentsystemofcurrencies.TheSDRimprovesinternationaltradeinseveralways:

Itdecreasesexchangeratevolatilityinthetradeoflargevolumesofcurrencybetweengovernments.SomenationshavegoneasfarastopegtheircurrenciestotheSDR.

ThesystembywhichSDRsareallocatedanddistributedhelpstofacilitatetheexchangeofforeigncurrencyreservestomeettherequirementsofIMFmembernations.

NationscanborrowSDRsatverylowinterestrates,stimulatinginvestmentandgrowth,particularlyindevelopingnations.

What does all this mean to you? The SDR acts very much like acurrencythatmediatestradeandforeignexchangecheaply,quickly,andeasily. The amount of foreign exchange currency that is available in anation doesn’t just come from thin air. The exchanges that occurbetween governments and other large institutions develop theinfrastructurebywhichsuchexchangesbecomepossibleintheircurrentform. The SDR, although less important than it oncewas, still has animportantroletoplaygivenitsnatureasanintermediarycurrencythatallows for the easy exchange of both fixed and floating currencieswithoutsacrificingtheabilityofanynationtomaintainpropermonetarypolicy.

38.FOREIGNEXCHANGERESERVES

Governmentsholdvaryinglevelsofanumberofforeigncurrencies,andsome quasi-currencies like gold, in something called foreign exchange

reserves.Themotivationsfordoingsoarefargreaterthansimplyhavingsomeextraspendingcash,although,inasense,thatisonereason.Thelevelsofeachspecificcurrencybeingmaintainedaredeliberatelychosenand changes are made only with careful consideration. As a nationincreasesthelevelofitsforeigncurrencyreserves,italsodecreasesthesupplyofthatcurrencyintheopenmarket.

WhatYouShouldKnowThere are multiple reasons to manage foreign currency reserves.

Currency reserves aremanaged inorder tomanipulate exchange rates.Byaltering reservecurrency levels, economicpolicymakers cancontrolthe exchange rate to maintain stability by decreasing the impact offluctuations,shocks,andspeculativemovements.Inaddition,holdingforeignexchangereserves,particularlyofreserve

currencies, helps to facilitate trade between the nation holding thecurrency and the nation from which the currency was issued. This isgoodforeconomicgrowthforbothnations.Finally,havingforeigncurrenciesonhandcanserveasaninvestment.

Although maintaining large foreign currency reserves carries asignificantrisk,itisinournaturetobeabitmoreboldinourholdingsofcurrenciesthatarestableorappreciating,whileeliminatingfromthereserves currencies that are depreciating in value or are otherwisevolatileinnature.

WhyYouShouldCarePractically every nation holds some quantity of foreign exchange

reserves,yetmostpeoplearen’tentirelysurewhy.Knowingexactlywhatthesereservesareusedfor,whyyournation isholdingthem,andhowtheyinfluencethevalueandquantityofcurrencyworldwideiscriticaltounderstandingthenatureofmoneyintheglobaleconomy.

CHAPTER5RestrictionsonTrade

Regardless of the overall gains and economic improvements that arecreated through trade, some feel threatened by increased competitionfrom international sources.Both a lackof understanding regarding theoverall benefits of trade and the inability of some companies andindividuals to adapt to the global economy contribute to publicresistance to foreign trade.This resistanceputspressureonpoliticians,as companies and individuals attempt to influence policy in order tomaketheirownorganizationsmorecompetitiveinthedomesticmarket.Regardlessofwhetherthemotivationforpromotingtraderestrictions

is misguided or self-serving, note that all trade policy set by agovernment isdomestic.Whileagovernmentcan, forexample,banalltrade between another nation and its own country, it can’t stop otherpeoplearound theworld from tradingwith thebannednation—exceptbyusing political or physical coercion. This chapter is concernedwithwaysinwhichgovernmentsrestricttheirownnation’stradingpractices.

39.TARIFFS

Oneofthemostcommonlyimplementedrestrictionstotradeisataxonimports—commonlycalledatariff.Tariffsareleviedonimportscomingintoanation,typicallywiththeprimaryintentionofmakingthemmoreexpensiveandthusdiscouragingpeoplefrombuyingthem.For a long time inWestern nations tariffswere a primary source of

government revenue; but in the early twentieth century they werelargely replaced by other taxes. This allowed governments theopportunity to use tariffsmore strategically as amethod ofmanaging

tradeandtheeconomy.Tariffs are set on specific items coming from specific nations;wholecorn is treated differently thanmilled corn, both ofwhich are treateddifferentlythancornsyrup,andsoon.Tariffs can be imposed either on a per-unit basis (for instance, in ashipmentof100tonsofcorn,eachtonistaxedseparately)orbyvalue(basedonapercentageofthepurchaseprice).

WhatYouShouldKnowTariffs are set when domestic industries are having difficultycompetingwithforeigngoods.Intheshortterm,thishaslimitedsuccess.If thepriceof foreign-madegoods goesup, peoplehave less reason tobuythem.Ifcomparableproductsmadedomesticallyarethesamepriceor cheaper, people will purchase them instead. This gives companieswithinone’sowncountryaboost,makingtheirpricesmorecompetitivecomparedtogoodsfromothercountries.However, the long-term effect is to prolong economic inefficiencies.Tariffs support noncompetitive businesses and eventually pass on thecostsofkeepingthemafloattotheconsumer.

WhyYouShouldCareIfyouwanttobuysomethingmadeinaforeigncountry,youshouldknowwhetheritspricealsoreflectsatariffthegovernmenthasimposedon it. If you’re a small business owner attempting to export goodsabroad,foreigntariffscanhaveaseriousimpactonyourcompany.

40.QUOTAS

Quotascaneitherincreasethecostofgoodscomingintothenationinamanner similar to tariffs, or they can limit the quantity of foreignimports.The former, called tariff-ratequotas, allowa setquantityofaparticulartypeofgoodtoenterthenationduty-free;thenanyadditionalquantitiesaresubjecttoatariff.Thelatterallowonlyasetquantityofaparticular good to enter the nation and once that quantity has been

reached, no additional imports of that particular good are allowed toenter at all. Quotas usually require the importing entity to obtain animportlicenseforaspecificquantityofthegoodsinquestion,obtainedfromwhatevergovernmentauthorityisinchargeofissuingthelicenses.Theselicensestypicallyrequireafee,increasingthecostsofimports.

WhatYouShouldKnowQuotasaimtoprotectdomesticjobs;theytendtobemoreeffectiveataccomplishingthisthantariffs,sinceaquotaguaranteesalimitedsupplyofaparticularimport,whereasthepriceincreaseresultingfromatariffmaynotgreatlyinfluencedemandfortheimport.On the other hand, quotas also cause more collateral damage thantariffs. Given that quotas tend to be more effective in accomplishingtheir short-term goals than tariffs, their impact on cost inefficienciestendtobegreater.Governments have been accused of distributing import licensesunfairlyforpoliticalgain.Whetherthatistrueornot,thosecompaniesthatobtainlicenseshaveaverystrongcompetitiveadvantageovertheirdomestic competitors. This anti-competitive circumstance allows a fewcompaniestocontroltheentireindustry.

WhyYouShouldCareAs a consumer you might not directly feel the effects of a quota.However,quotasaddcomplexityforthoseorganizationsthatimportandexport goods. It is not as simple as merely paying an additional feeduringthecourseofbusiness-as-usual.Onemustbeawareofcompaniesthateitherhaveimportlicensesorarefrequentholdersofsuchlicenses.Those organizations must be targeted for sales rather than merelymarketingtoallpotentialcustomersasonemighttypicallyattempt.Some companies specialize in obtaining licenses and distributinggoodsbetweennations.Thesecompanieswillselltojustaboutanyone.Ifyoudon’tmindbuyingbulkquantities,individualscansavequiteabitof money this way as well, not to mention having access to a widervarietyofproducts.

41.SUBSIDIESANDDUMPING

Theoppositeoftariffs,subsidiesarepaymentsthegovernmentmakestoorganizations to either produce or export a particular type of good.Agricultural concerns are frequent recipients of government subsidies.Farmersproducecorn;thenthegovernmentpaysthemasetamountforeveryunitofcornproduced.Sometimesgovernmentsprovidesubsidiesonexports,payingpeople to shipgoodsoverseas rather thansell themdomestically.Thepurposeofasubsidyistomakethegoodscheaperforconsumers.

Thegovernmentpaysaportionoftheproductionorexportcostssothatthe producer can charge a lower price. However, countries that paysubsidiestoexportgoodsaresometimesaccusedof“dumping.”Dumping occurswhen the exporters of one nation sell goods to the

people of another nation “below fairmarket value.” The strategy is toforce foreign competitors out of business. Some commentators havearguedaboutwhetherdumpingreallyexists,orwhetherperceivedcasesofdumpingaremerelytheresultofcombiningacompetitiveadvantagewithadomesticsubsidy.

WhatYouShouldKnowAlthoughnoteverysubsidyisintendedtoallowcompaniestocheaply

dump their goods overseas, any good that receives a subsidy and issubsequentlyexportedissoldatapricebelowwhatwouldnormallybepossible. While this certainly helps a company or industry obtain agreater share of the global market, it is very expensive and notsustainableinthelongrun.Suchastrategywilldolittlemorethanforceglobal cost inefficiencies, as those companies that survive will haveincreased costs and higher prices. When a subsidy gives one nation’scompaniesanunfairtradeadvantage,sometimesimportingnationswillimposeatariffroughlyequaltotheamountofthesubsidy;thisiscalledacountervailingduty.

WhyYouShouldCareOneof theprimary reasons for trade is tobenefit thepeopleof one

nation by seeking out sources of goods and services that are cheaperabroad. For a government to subsidize its own companies in order tomake them more competitive against foreign firms is a grossmisallocationofassets.

42.EMBARGOES

Embargoes are themost extreme form of trade restriction that can beenforcedwithoutmilitary intervention.An embargo is a complete banon trading specific typesof goodsbetween twonations.Embargoesontheexportofarmsandothermilitarygoodsarequitecommon.Beyondmilitarygoods, though,embargoesonother formsofgoodsareusuallyimplemented as a result of political conflict between nations, but alsosometimesbecauseofhealth.AfteranoutbreakofMadCowDiseaseinthemid-1990scausedpeopletofeartaintedmeat,manynationsplacedatemporaryembargoonBritishbeef.An embargo completely stops trade. A travel embargo keeps peoplefromtraveling toor fromaparticularnation.A fullembargostops thetwonations fromhavinganycontactatall.Cubawasunderanalmostcomplete embargo by the United States for many years, a policy thatdevastated theCubaneconomy.At last theembargowaseasedenoughtoallowformedicalandhumanitarianaidtoenterthenation.

WhatYouShouldKnowForanationoranindustryunderanembargo,theonlystrategyistofind alternative places to buy and sell goods. Embargos can happenwithoutwarning,it’simpossibletotellhowlongthey’lllast,andthere’snogoodwaytocircumvent themwithoutbreakingthe law(somethingthatisilladvised).

WhyYouShouldCarePriortotheU.S.embargoofCuba,theUnitedStatespurchasedaverylargeproportionof oneofCuba’s largest industries: sugar.As a result,sugar from Cuba was extremely cheap in the United States. As foodpricesrisearoundtheworld,theUnitedStatescontinuestomaintainan

embargothathasaccomplishednothingofitsoriginalgoalsasstatedin1960 yet could help ease food prices in this country by once againallowingfortheimportofverycheapsugar.

43.VOLATILITY

Volatility is a social andpoliticalproblem.Whilenot intended tobeatrade barrier, it often results in reduced trade. Volatility refers toanything within a nation that lacks a predictable trend, particularlythosethingsthatexperiencewildchanges.If a nation’s currency is volatile (in other words, the value of the

currency changes dramatically and frequently), many people do notwanttobepaidinthatcurrencybecauseitmaybeworthlessinthenearfuture. If anation’sgovernment is volatile (e.g., factions struggling forcontrol,violentcrackdownoncivilians,etc.), then itbecomesdifficult,andsometimesdangerous,totradewiththecountry.

WhatYouShouldKnowEvery nation experiences fluctuations but these are almost always

withinparameterswith littleornorisk.Thekindofvolatilitythatwillrestrict trade causes changes that are relevant to the operations of abusiness or the mechanics of a transaction. These shifts are frequentenoughfortheirveryinconsistencytobepredictable.Nations with larger economies can often minimize volatility by

diversifyingthetypesofgoodstheyproduce(ratherthanrelyingonjustafewtypesofgoodsthatmightfluctuateinsupplyanddemand).Theyalsotendtohavelesssocialandpoliticalvolatilityasaresultofhavingreasonablyample resources for thepeople tomaintainaqualityof lifethatdiscouragesconflict.

WhyYouShouldCareVolatilityisanindicatorratherthanacauseofproblems.Still,itcan

beabarriertotrade,andtheunderlyingcausesofthevolatilitymustberesolvedbeforethenationcanmoreeffectivelyattracttrade.Fixingtheproblems that cause volatility is a topic more associated with

developmentaleconomics,touchedoninChapter10.

44.COUNTERFEITINGANDIPVIOLATIONS

Counterfeitingandviolationsofintellectualproperty(IP)lawareamongthemostseriouseconomiccrimesinexistence.Theyarecloselyrelated,and,sadly,botharewidespread.Brand-name goods that are much in demand will often stimulate

widespreadproductionofknockoffversions.Theseviolationscreateadefacto trade restriction, since high-profile brand companies will oftenrefuse to export to nations with known counterfeiting problems.Counterfeitingreducesnotonlythenumberofsalesthatacompanycanpotentiallymakebutalso thevalueof theoriginalbrand, sincepeopleassociatetheinferiorfakegoodswiththeoriginals.

WhatYouShouldKnowCounterfeiting often calls up a picture of a guy selling fake Rolex

watchesoutofthebackofavan.However,itcandipintolargerethicalgrayareas.Forinstance,drugsmeantforHIVpatientstendtohavehighpricesbecauseresearch isexpensive.Once thedrug isavailableon themarket,however,unscrupulouscompaniescanreplicateitverycheaplybecauseofthelackofresearchcosts.InSub-SaharanAfrica,whereHIVratesarehigherthaninanyotherpartoftheworld,importeddrugsthatcould save the lives of millions are too expensive for widespreaddistribution.However,domesticallymadegenericversionsareoftenwellwithinthepricerangeofthosewhoaresick.Should foreign pharmaceutical companies export to these nations

wherecounterfeiting is socommon,knowing that theyaresaving liveswhilestillmakingafewsales?Orshouldtheyrefusetoselltheirdrugsto thesenations at all because theywill be counterfeited, taking awayfundingforfuturepharmaceuticalresearch?Thesequestionsarenoteasytoanswer.Thepopularityoffile-sharingprogramssuchasNapsterorBitTorrent,

althoughnotasethicallycomplex,isreallynodifferent.Foralongtime

therehadbeen little effort among record labels ormovieproducers todistribute their media more cheaply. Napster, it could be argued,illustrated that a demand wasn’t being met. The result: iTunes. Thisinnovationfueledanexplosionofdevices tostoreandplaythismedia,including tablet computers, smartphones, MP3 players, eBook readers,andmuchmore.Despite this example, companies tend to avoid exporting to nationsthathave seriouscounterfeitingproblems, seeing itas toogreata risk.Thesecompaniesfailtorealizethatblackmarketsarenaturalproblemsthat form from differentials in supply and demand. The solution isinnovation.

WhyYouShouldCareCounterfeiting, IP violations, and (more recently) media piracy arehotlydebated.The reason for theconfusion is thatboth sides, in theirown way, are correct. Although the potential benefit that companiesexperiencefromtradeisgreat,theriskcanbeequallygreat.Theriskofcopyright infringement increases as companies trade internationally.Assessing thedegreeof risk involvedthendeterminingthebestwaytomitigatethatriskisacriticalstepintrade.

45.INFRASTRUCTURE

Those physical structures, facilities, and connections that make itpossible forcompaniesandcommunities to functionmakeupwhatwecall infrastructure. It’s a necessary logistical component that makesinteraction and distribution between people possible. Key elements ofinfrastructureinclude:

Roads

Bridges

Canals

Airports

Electricpowergrids

Naturalgasandoilpipelines

Sewersystems

Irrigationsystems

Coastalmanagementstructures

Dams

Postalservice

Telephone

Internet

Communicationssatellites

Parts of infrastructure depend on each other. For example, anelectricalgeneratorofany sort (e.g., coal,nuclear,wind, solar, etc.) isuselessunlessthatenergycanbemadeavailabletopeopleonamassivescale. The infrastructure itself, in this case, includes power lines,junction boxes, usage meters, power stations, and, arguably, the staffrequired to manage the power stations, read the meters, manage theaccounting, and everything else that’s involved to ensure electricityremainscontinuouslyavailable.

WhatYouShouldKnowOneof themajor problemswith infrastructure is that it’s expensive tocreate and maintain. While most infrastructure projects hold thepotential to be profitable, the majority are still funded by thegovernment.In global economics, infrastructure typically refers to three primarythings:transportation,communication,andinformation.Transportationmeansthatpeopleandobjectsmustbeabletomovebetween different physical locations, including shipments of goodsbetweennations. Transportation infrastructure includes airstrips,waterports,roadsandfreeways,bridges,fuelpoints,supplypoints,andmore.Communication and information infrastructures overlap because

they frequently use the same systems. Some of the most commoninfrastructures that allow for international communication andinformation transmission include shipping andmail systems, telephonenetworks,andInternetavailability.

WhyYouShouldCareWithouttheinfrastructurerequiredfortransnationalcommunications

and distribution, trade cannot take place. Without the proper tradeinfrastructure, global economics grinds to ahalt. This has beenoneofthe largest challenges throughout history, spurring the construction ofthe Panama Canal (a project that failed multiple times before finallybeing completed in 1914), and the railroad systems throughout Africa(whichhavealsobeenprimarilyafailure).

46.ENVIRONMENTALANDCONSUMERPROTECTIONREGULATIONS

Aren’tlawsthatprotectconsumersortheenvironmentagoodthing?How can such laws possibly be harmful? Chances are good that youthinkI’maschmuck.Hearmeout.Ineversaidthatenvironmentalandconsumer protection lawswere bad or good—simply that they restricttrade.Yes,manypeoplethink,forexample,thatmakingthewatersafetodrinkisanoblecauseandonethatmakeseconomicsense.Butwe’retalking about trade.Although a government that protects its source offreshwater will have healthy people, itmay also increase the cost ofproduction for domestic companies as well as repelling companiesanxioustotradeustheircheaperwatersupply.Is it right forcompanies toharmcustomersor theenvironmentwith

recklessbusinesspracticesanddangerousproducts?Somearguethatitisappropriate; others disagree. Is it up to the government to create lawsthatprotectusfromsuchthings?That’salsodebated.TheonlypointI’mmaking here is that these laws do, in the short run,make productionmore expensive. If a company spends a lot ofmoneymaking sure it’ssafelydisposingofwaste,thecostofitsoperationsincreasesanditmustincreaseprice,makingitlesscompetitiveininternationaltrade.

WhatYouShouldKnowEnvironmental and consumer protection regulations force companies

to adhere to standards that increase costs, limit distribution, andotherwise hinder business. Because these laws differ from nation tonation, two things happen: some businesses are less competitive andsomeforeignbusinessesstopexportingtheirgoods.Whether the laws themselves make economic sense needs to be

studied on a case-by-case basis, but any time a business must meetadditional requirements in order to continue daily operations, theirfinancial performance is constrained. By the same token, when goodsmustmeetminimum requirements in order to be sold legally, foreigncompanies also incur additional costs. For years, Chinese-owned carmanufacturer Geely has attempted to export vehicles to the UnitedStates, but its cars do not meet emissions standards. This restrictiondirectlylimitedtrade.

WhyYouShouldCareDuring the early twenty-first century, the dangers of poor consumer

protection enforcement inChina became apparent as a series of faultyproducts, including poisoned toothpaste and lead-tainted toys, harmedglobalconsumers.Obviously, suchrecklessabandon isnotappropriate,andproperlawsmustbeenactedtoproviderecoursefordamagesdonetoconsumers.However,somestillstronglyresistsuchlaws.The trick is to determine whether the law in question creates

economicbenefitorisbeingimplementedsimplyasameasuretoprotectdomesticproduction.It’snotaneasytask,sincenobodyactuallyclaimstobesupportinglawsthatarepurelyself-serving,butitisnecessarytounderstandwhetheralawisgoingtohurtyouorhelpyou.

47.TRADEWAR

Trade wars occur when two or more nations use trade restrictionsagainst one another to the point that these restrictions becomegeneralized.NationAplacesa tariffongoodsexported fromNationB;

thatcountryfeelsthatthisunfairlyrestrictstradesoitissuesatarifforquotaonNationA.Andfromtherethingsescalate.Such economic tactics meant to hinder trade between two nations

mightincludeanyofthetraderestrictionsmentionedthusfar.Theyalsomight include specific methods of managing exchange rates and evenextendtomoreaggressiveformsofeconomiccombat.Inextremecases,tradewarfarespillsoverintophysicalwarfare.

WhatYouShouldKnowTheWorldTradeOrganizationhasbeengreatlybeneficial inlimiting

notonlythenumberoftradewarsthathaveoccurredbuttheirseverity.MembernationscanappealtotheWTO,whichwillprovideanunbiasedanalysis of the circumstances to determine whether trade restrictionsviolate WTO rules. This has helped increase the role of diplomacy inresolvingeconomicconflicts, similar to thegoalsof theUnitedNations(althoughtheWTOisbetteratwhattheydo).

WhyYouShouldCareTrade wars occur much more frequently than traditional forms of

warfare,althoughtheyareoftenresolvedinsuchatimelymannerthattheycanhardlybecalledwars.Still,thedamagethatoccursisreal.Thedecision to launch a tradewar ismade not because it is economicallysound but because it is politically convenient. The actual economicimpactofthoserestrictionsisharmfultoallnationsinvolved.

CHAPTER6ManagingGlobalRisk

Theworld is filledwith risk.However, justbecause something is riskydoesn’tmean that it should be avoided entirely. Risk is nothingmorethanapotentialcostandmustbeassessedforbothpotentialmaximumloss and probability. There aremany types of risk, all associatedwithdifferentaspectsoftheglobaleconomy,andallofthemcanbemeasuredto determinewhether a particular action is advisable.Whenmanagedproperly,riskcanbebothpredictedandmitigated;thecosts,anticipatedin advance as a part of analysis, reveal the expected benefits ofexpandinggloballyandhowtheorganizationmustprice its services inordertostayprofitable.All importantformsofriskareassociatedwithsometypeofreward.Managingglobalriskisamatterofmeasuringtheexpected benefit against the potential losses and the probability thatthoselosseswillbeincurred.In this chapter we’ll discuss the different types of risks as well as

severalcommonmethodsforlimitingtheamountofriskassociatedwithinternationaltransactions.

48.TRANSACTIONRISK

Exchangeratesbetweencurrenciesgoup,down,andmoveallaroundina never-ending dance. Whether you gain or lose any of that wealthdependsgreatlyonwhichcurrencyyouhaveorareexpectingtopossessandwhichwaytheexchangeratesaremoving. The potential for a loss of value resulting from a change inexchange rates is known as foreign exchange risk. Of course, just asthereispotentialforlossfromachangeinexchangerates,sotoothereisachanceforgain.

Let’s say you own a car company—we’ll call it Your Car Company(YCC).Youplantoexport100carsfromtheUnitedStatestoEnglandforatotalrevenueofGBP100,000.Atthetimeyousignedthisagreement,oneU.S.dollarwasequalinvaluetooneBritishpound,soyoubudgetedforanincomeofUSD100,000.However,bythetimetheexchangetakesplacetheexchangeratehasdropped.OneU.S.dollarisnowworthtwoBritishpounds.Allofasudden,you’renotgettingUSD100,000anymore;you’renowgettingonlyUSD50,000.On the other hand, suppose YCC owns a dealership in England andplanstopurchase100carsfromtheUnitedStatesforUSD100,000.IftheBritish pounddrops in value relative to theU.S. dollar, you’ll have topay more pounds in order to fulfill your contracted obligation forUSD100,000.Inboththesesituations,you,theownerofYCC,losemoneybecauseofthechangeintheexchangerate.Ontheotherhand,sinceexchangeratescanincreaseordecrease,it’spossiblethatYCCcouldmakemoremoneyorspendlessasaresultoftransactionrisk.Whenacompanydeterminesthat theexchange rate isgoing tochangeand tries tomakemoneybybuying currency that is going togoup, this is called foreignexchangearbitrage(arbitragemeanstakingadvantageofthedifferenceincurrentpriceandexpectedprice).

WhatYouShouldKnowTheriskinexchangeratefluctuationisthatthecurrencyofexchangelosesvalueandyouenduppayingmoreor earning less thanyouhadoriginally anticipated. Note that in the case of transaction risk, oneperson’s loss is very often the other person’s gain. As a result, foreignexchangeriskholdsbothriskandpotential.Acompanymayanalyzethisrisk (and many others) to either decrease the amount of loss theyexperienceorincreasetheamountofrevenuestheyearn.Companies trying to takeadvantageof foreignexchange fluctuationstypicallydosothroughassetmanagementratherthanattemptingtodoso through their purchases and sales. In other words, many prefer tomaintain as little transaction risk as possible since the gain or loss onsuchforeignexchangefluctuationscanbedifficulttopredict.Nations that have large, stable economies tend to be associated less

with transaction risk. Of course, organizations that participate insignificantly large international transactions will be at greater risk forevensmallchangesinexchangerate;thosenationswithmorestablefiatcurrencies—or currencies where the money derives its value fromgovernmentregulation—usuallyexperiencelessvolatility.

WhyYouShouldCareExceptbetween twonationswhose currencies arepeggeddirectly tooneanother,transactionriskisanissueforeverytransactionthatoccursacrossnationalborders.Asapracticalmatter,sinceeverytimeyoubuyanything, there’s a very good chance it wasmade, at least in part, insomenationotherthanyourown,you’redirectlyaffectedbychangesintheexchangerate.Most businesses that regularly transact business over multiplecurrenciesaccountfortheexpectedlossesassociatedwiththisrisk,oratleast the costs of mitigating the risk. This is reflected in their pricingstrategy, causing the price of the goods you’re purchasing to besomewhathigher.

49.POLITICALRISK

Theroleofanation in theglobaleconomyis set, in largepart,by thegovernment in charge of that nation. The policies of that governmentdefinehowthenationinteractswithothers,howcompaniesparticipatein trade, and the degree of risk that organizations attempting to tradewiththatnationface.Achangeingovernmentpolicycangreatlyhelporharmnotonlyindividualsorcompanies,buttheentireglobaleconomy.Forexample, it isnotuncommonforgovernments torestrictwhat isallowed to leave the country. Laws often either limit or completelyprohibitcitizens(andnoncitizens)fromtakingassetsoutofthenationinwhichtheycurrentlyreside.Thesearecalledrepatriationrestrictions.Political risk shouldnotbe assessedat just thenational level.Whilepaying attention to the federal government of a nation can beinformative, these smaller governments often have a significant

influence on regional economies. While local governments cannottypicallysetpolicyrelatedtotrade,theycaninfluencetradewithintheirjurisdiction.

WhatYouShouldKnowCompaniesassesspoliticalriskbasedontwoprimarycategories:micro

andmacro.Microriskincludesthepossibilitythatthegovernmentwillpass somepolicy that influenceseither individualcompaniesor sectorswithinthenation,orevenindividualprojectsonwhichtheorganizationmightbeworking.Macropoliticalrisk,ontheotherhand,includespoliciesthatapplyto

all organizations, often from all nations. These can include tradepolicies, currency policies, immigration policies, and awide variety ofother actions. In theUnitedStates, theBuyAmericanAct is a formoffar-reaching policy that representsmacro political risk for any foreigncompanythathadpreviouslysoldgoodstotheU.S.federalgovernment(theactrequiresthegovernmenttoattempttosourceall itsgoodsandservicesfirstfromU.S.suppliers).

WhyYouShouldCarePolitical decisions often have absolutely no economic benefit or at

least none that’s immediately obvious. Thismeans there is really onlyone way to manage political risk. Instead of merely accepting thatpoliticians are completely insane, many companies attempt to beproactive in their approach by persuading politicians to include theirinput in policy decisions. They do this by providing information,consultinginimplementation,hiringprofessionallobbyists,havingtheirexecutives actually apply for political positions, or making campaigncontributions.Thiscontroversialbuteffectiveapproachisn’twelcomeinallnationsbecauseitdoesnotresultinsoundeconomicpolicies.

50.INTERESTRATERISKANDINFLATIONARYRISK

Interest rate risk and inflationary risk are faced by investors but

internationalexpansionactuallyallowsthemtomitigatetheseverityoftheserisks.Thisisdonebygivinginvestorswithinternationaltiestoolstotransferassetsbetweenthetwonationsinordertotakeadvantageoftherelativedifferentialsininterestratesandinflationrates.Inflationaryriskreferstouncertaintyregardingthefuturerealvalueofone’s investments. Say, for instance, that you hold $100 in a bankaccountthathasnofeesandaccruesnointerest.Ifleftuntouchedtherewillalwaysbe$100inthatbankaccount.Ifyoukeepthatmoneyinthebank for a year, duringwhich inflation is 100percent…well, you’vestill got $100.Only now, if you take it out and put it in yourwallet,you’llonlybeabletopurchasehalfthegoodsyoucouldhaveboughtayearago.Inotherwords,ifinflationincreasesfasterthantheamountofinterestyouareearning,thiswilldecreasethepurchasingpowerofyourinvestments over time. That’s why we differentiate between nominalvalue and real value. Nominal value is the total number of units ofcurrencyyouhave,whiletherealvaluereferstochangesinthevalueofthatmoney,takinginflationintoaccount.Interestrateriskreferstotheamountofuncertaintythatinterestrateswillincreaseafteryoupurchaseaninterest-bearinginvestment.

WhatYouShouldKnowIn global economics, we’re less concerned about interest rates orinflationratesthanweareaboutthedifferencesintheseratesbetweennations.Wealreadyknowthatbothinflationandinterestratesinfluenceexchange rates, and that can be an important variable when decidinghowtomanage themovementofyourcapitalassetsaround theglobe.Forthemomentwe’regoingtoassumethatexchangerateswillstaythesame.Whentherearedifferencesininflationratesbetweentwonations,theonewiththelowestinflationhasthelowestrisk.Ifyouhave100unitsofcurrency in eachof twonations, andonehas10percent inflationandtheotherhas1percentinflation,yourassetswillbeworthmoreinthenationwiththelowerinflation.Itdoesn’tnecessarilymatterwhereyouholdyourassetsbecausethenominalamountofcurrencywon’tchangeas a result of inflation rates (remember: we’re keeping exchangeconstant).Butwhenyouusethecurrency,itwillbeworthmoreinthe

nation with lower inflation. If we now take changes of exchange rateintoconsideration,wecanseethatkeepingyourassetsinanationwithlower inflationwill bemore beneficial because the high inflationwillharmthevalueofyourassetswhenexchangingbetweencurrencies.Differences in interest rates between nations form an interesting

dynamic.Typically,withinasinglenation,youwanttoinvestinbondsthat have the highest interest yield for the amount of risk you’reincurring.It’scommontotimetheseinvestmentssothatyoubuybondswhen interest rates are at their highest and not likely to increase anyfurther. When investing internationally, it’s quite possible that theinterestratesinanothernationcouldcontinuetoincreasepastthepointat which your own nation’s interest rates stop. Understanding bothnationsnotonlygivesyouadditionalpotentialforinvestmentgains,butalso gives you the opportunity to trade between nations in order togeneratethegreatestreturns.

WhyYouShouldCareIf you’re generating 5 percent interest on your investments but

inflation is10percent,you’restill losing5percentof therealvalueofyour investments. On the other hand, if your investments in anothernation are generating 3 percent return and inflation there is only 2percent, you’ll have higher real value. Since we know that thedifferentials in inflationand interest ratesdo, in fact,changeexchangerates,you’dgainthegreatestbenefitsbykeepingyourinvestmentsinthenationwiththelowerinterestratesbutthehighestdifferentialbetweeninterestratesandinflationrates.

51.TRANSLATIONRISK

Whenanorganizationownsforeignoperations,listsforeignassetsonitsbooks,orownsassetsdenominatedinaforeigncurrency, any fluctuation in exchange rates between the foreign-denominatedassetsandtheprimarycurrencyofthecompanywillalteritsbookvalue.Bybookvalue,we’rereferringtothetotalvalueofalltheassets held by the organization, including buildings, equipment, cash,

andstocks.Let’s say, for instance, that you own 10,000 Mexican pesos (that’s

MXP10,000).Theydon’tbelongtoacompanyorotherorganization;youjusthave themstored inacoffeecan inyourkitchen. Ifyourcurrency(let’sabbreviateitURC)isonparwiththeMXPyou’vegotURC10,000orMXP10,000—itdoesn’treallymatterwhichwayyouthinkof it.Butsuppose the MXP increases in value 10 percent compared to yourcurrency. Now your coffee can of money is worth URC11,000 ratherthan the original URC10,000, plus whatever you can get for the canitself.Thatsoundslikeagreatopportunity! Increaseyournetvaluebyjust

holding on to foreignmoney, right?Well, not if you’re holding on toURC and living in Mexico. If that’s the case, the value of the moneyyou’re holding is less than before the change in exchange rate. That’swhythisisconsideredarisk.

WhatYouShouldKnowAs with transaction risk, translation risk is a threat that requires

mitigatingoranopportunity tobenefit. It’sabiteasier todo thiswithassetsyoualreadyown,becauseyoucankeepyourassetsdenominatedinanothercurrency foranextendedperiodof time.Since therearenoother parties involved (except, sometimes, the bank exchanging yourcurrency)youcanmoreeasilyswitchbackandforthbetweencurrencies.Still, this can be an extra risky strategy. Many prefer to focus onreducing risk and allocating assets internationally based on therequirementsforoperationsandgrowth.Asacompanydevelopsanever-increasingamountofforeignassetsas

aresultofexpandingoperations itplaces itselfatriskto losecompanyvalue,particularlyifanysignificantamountofthoseassetsarelong-termphysicalcapitalsuchasproperty,plants,andequipment,whichcannotbeeasilytransferredbetweencurrenciesorcountries.As with transaction risk, those nations that have larger, more

diversified, or more otherwise stable economies tend to have lowerproblemswithtranslationrisk.Theriskincreaseswithnationsthathavelarger fluctuations in economic production (particularly those that arereliant on seasonal production) and those small or moderately sized

nations that have not pegged their currency to a more stable fiatcurrencyorbasketoffiatcurrencies.

WhyYouShouldCareTherealriskassociatedwithcurrencytranslationisthatthevalueofacompanycould, theoretically,drop tonearlynothingwith littlehavingchangedexceptanexchangerate.Ofcourse,suchadramaticshiftwouldlikelymean that therewere someunderlyingproblemsassociatedwiththenationaleconomy,buttheactualoperationsorcompetitivestrengthof an organization need not necessarily change except in terms offinancial translation. This drop in value would influence not only theorganization itself, potentially harming it beyond repair, but alsoinvestorsandlendersforthatcompany,andanyotherstakeholderssuchasemployees,consumers,and,inthecaseofespeciallylargecompanies,the economy of both nations. For these reasons it is particularlyimportant for organizations operating in nations that have volatileeconomiesand/orcurrencieswithvolatileexchangeratestotakespecialprecautionsagainsttranslationriskforitsstandardoperations.

52.LEGALRISK

Noteverynationontheplanethasalawenforcementsystemthatworks;nordo theynecessarily recognize foreignor international law.Whenacompany has difficulty with a foreign legal system, it’s just incurredlegal risk. As a rule, foreigners often have far more difficulty thannativeswithahostcountry’slegalsystem.That’snotalwaystrue(manynationsgooutoftheirwaytotrytoimpressforeigners),butasageneralrule it ismoredifficult for a foreigner thana local tonavigate a legalsystem.One specific type of legal risk, called settlement risk, refers to ascenario in which an exchange is agreed upon but only one partyupholds its obligations in delivering either payment or goods. Acrossinternationalborders,what recoursedoes the injuredpartyhave?Thatdependsgreatlyonthedetailsofthecontract.In such a case, if one is even capable of getting a court to take an

interest in a case presented by some foreigner, there is the distinctpossibilitythatitwilltakesolongtoevenbegintheprocessthateitherthe costs associated with the entire process will exceed the potentialbenefit of pursuing the case or the transaction itself will becomeoutdated andmeaningless. As already noted, not all nations have thisproblem nor will all organizations experience this problem, but thisparticular form of risk becomes especially important to be aware ofbecausethereislittlethatonecandotominimizetheissueonceithasalreadyoccurred.

WhatYouShouldKnowLegal risk comes fromanumberof sources.Firstof all, thenationallegal infrastructure plays a large role. If it’s very small, overburdenedwith toomanycasesandnotenoughresources toenforce theverdicts,actions you bring may not be heard. In addition, a weak legalinfrastructuregivesincentiveforconartistsandotherstotakeadvantageofforeigners.Another issue that contributes significantly to legal risk is thecountry’sculture. Insomenations it isacceptable to takeadvantageofimbalances in information between the parties to a transaction(colloquially:toripsomeoneoff).Companiesmustdeterminehowwhatwewouldthinkofasdishonestactivityisviewedwithinanationwheretheywishtodobusiness.Thepoliticalgoalsofagovernmentcanplayapart indefining legalrisk.Of course, thesegoals can create such riskaswell. It dependsonwhetherthegovernmenthasdeterminedthatit isinitsbestinteresttoprotectlocalcompaniesfromunwantedforeignersorwhetheritwantstoattractforeigninvestorsandtraders.

WhyYouShouldCareThemostimportantinstrumentinmitigatinglegalriskisthecontract.Arbitration can often be a quicker and less expensive process thanlitigation. Arbitration is handled by a private individual or companyratherthanthegovernmentalcourtsystem.Thisoftenallowstheprocesstonotonlymovemorequickly,butitisalsooftenlesscostlythanalegalcase while still providing a binding judgment. However, while

arbitrationisbinding,littlecanbedonetocompeleitherpartytofulfilltheirobligations.Anotherway tomitigate risk is tomandate in the contract that any

litigationwill take place in the nationwith themore responsive legalsystem. While these preventative measures can help, there is noguaranteedwaytoeliminatelegalrisk,andevenapositiveoutcomecanbeextremelycostly.

53.CONVERTIBILITYRISK

Convertibility risk refers to the possibility that a particular currencycannotbeexchangedorconverted(hencethename“convertibilityrisk”)intoanothercurrency.Thishappensmostfrequentlywithcurrenciesthatareveryvolatile—forinstance,thosebelongingtonationsthatareinthemidstofwarorrevolution,orcurrenciesexperiencinghyperinflationorotherdramaticmonetaryproblems.Basically,convertibilityriskappliestothosecurrenciesthatarecompletelyworthlessoutsidethenationthatoriginallyissuedthem.For example, suppose you earned money from working in another

nation.You’vebeenpaid in that country’s currency.Everything’sgreatuntil the currency changer suddenly tells you they can’t exchange theforeigncurrencyyou’regivingthem.Nowyou’restuckwiththewadofmoneyyoucan’tuseinanyothernation.

WhatYouShouldKnowInconvertibility occurs when nobody wants the currency you have.

Thishappensintwoprimaryways:

1. Thegovernmenthasprohibiteditscurrencyfromleavingthecountry

2. Peoplehavelostfaithinthecurrency

Theformerproblemisprettysimple—ifthegovernmentdoesn’twantits currency converted into other money, it’s worthless to everyoneoutsidethenation.Lawsaboutthisareimplementedfromtimetotime

innationswithvolatileeconomiesinmisguidedattemptstokeepassetsfromleavingthem.When people lose confidence in the currency, that’s a much bigger

problem—foryouandforthegovernmentthatissuedit.Rememberthatacurrencyonlyhasvaluebecausepeoplebelievethattheywillbeableto exchange it for goods and services. If a nation produces nothinganybodywants,thecurrencyisworthless.Ifpeopledon’tknowwhetherthenationwillexistforlongorthattheirproductionwon’tcontinue,noonewantsthecurrencyWhatcanyoudowithnonconvertiblecurrency?Youcouldholdonto

itandhopethatitwilleventuallybetradedagain.Oryoucouldtrytofindwaystouseitwithinthenationoforigin.Oryoucouldtrytradingitontheblackmarket,whichprobablywon’tgetyouagreatprice.Butafterall,acceptinglowervalueisbetterthanholdingontoalargepileofuselessmoney.

WhyYouShouldCareWhen you’re getting ready to go on vacation, be sure that you can

exchange any foreign currency you accumulate back into your homecountry’smoney.Currencies thatarenonconvertible typically stay thatway for awhile, so attempting to takeadvantageof the lowexchangevalueinthehopesthatitwillincreaseafteritcanbeconvertedagainisnotusuallyadvised.Thebestwaytoreduceconvertibilityriskistoavoidthecurrencyaltogether.Ifyoucan’tdothis,figuretheexpectedamountofcurrencythatwillremaininconvertible.Onceyou’vedeterminedthis,you can measure that potential cost against the money you’ll receivefromoperatingwithinthatnation.

54.RISK-FREEASSETS

For investors and organizations thatmaintain holdings in a significantamount of assets, particularly liquid assets, expanding internationallycanbothincreaseanddecreaserisk.Althoughexpandinginternationallycanhelptodiversifyoperations,therebyreducingrisk,asalreadynotedin thischapter,expanding internationallyholds itsownrisks.Oneway

to limit theriskassociatedwithholding international investments is topurchaseaclassoffinancialproductscalledrisk-freeassets.Risk-freeassetsarethoseseenbythosewhoholdthemtohavelittleor

no riskof losingvalue.They include short-term interest-bearingassets,suchas treasurybills (or similarequivalent formsofgovernmentdebt)andtimedsavingsaccountssuchasshort-termorno-penaltycertificatesof deposit (or any equivalent foundwithin a particular nation). Theseassets are considered risk-free because they provide a guaranteedpercentage interest rate return. That limits the amount of risk of lossassociatedwithmorevolatileinvestmentassetssuchasequitiesbutstillprovides more return than keeping the money in a simple savingsaccount.Inaddition,theseassetsarestillveryshortterm,unlikebonds,so that there is very little risk of incurring losses associated withincreasesininterestratesorinflationsincetheycanbewithdrawnandreinvestedelsewhere,usuallywithinaveryshorttimeperiod.

WhatYouShouldKnowMaintaining risk-free assets is a popularway to help companies and

investorsmaintainthevalueoftheirliquidassets.Atthesametime,risk-freeassetsdon’tyieldhighreturns;forthatyoumustlooktoevenriskierassetssuchasequities.Allthesedifferentformsofinvestmentsandassetholdings will be discussed in greater detail in Chapter 7. For now,though,we’reconcernedaboutmanagingrisk.Inorderfororganizationstolimittheamountofriskassociatedwithholdingliquidassetssuchascash, investing in risk-free assets can help reduce the amount of riskassociatedwithnationsthatareexperiencinghighinflationorexchangeratedifferentials.Not all types of risk-free assets are available in all nations, nor are

theynecessarilyalwaysavailable to foreigners.Timedaccounts (whicharebasicallyindistinguishablefromcertificatesofdeposit)arerelativelyuniversal.

WhyYouShouldCareEachnationmanages its own economy and, as a result, eachnation

hasdifferentratesofinflation,interestratesofreturn,andrisk.Youcanuse this toyouradvantage.Let’s sayanorganizationhasoperations in

both Nation A and Nation B. Nation A has inflation of 1 percent andinterestreturnsof2percent,whileNationBhasinflationof1.5percentand interest returns of 3 percent. Assuming there is no change inexchange rates between the two nations, even though Nation B hashigherinflationratesthatwillreducethevalueofaconstantquantityofassets, it alsohas interest rate returns thatmore thanmakeup for theinflationrate.YourbestbetwouldbetomaintainyourassetsinNationB.Beingawareofrisksandopportunitieswilloptimizeyourvalue.The

returnsonrisk-freeassetsareusuallyverylow,sothepossibilityofusingthis as a strategy for increasing wealth is minimal, but there are anumberofoptionsforlimitingrisk.

55.INSURANCE

Probablythemostcommonmethodoflimitingriskisinsurance.Youcaninsure just about anything: vehicles, your health, buildings, machines,land, specific body parts, antiques, shipments of packages, and eventravel.Whenyouinsuresomething,itmeansthatyou’redistributingtherisk of loss among a larger set of people, so an individual whoexperiencesaproblemwillincurfewercostsassociatedwiththeoriginalloss.Inotherwords,youpayacompanytotaketheriskforyou.Asfaras theglobaleconomygoes, insurancedoesthesamething: It

helpsdistributetheriskthatindividualsandorganizationsface.Thecostofanylossispaidforbythefundsgeneratedbythepaymentofmonthlypremiumsmadebyallthosewhoareinsured.Thishelpstomanageriskby limiting the total potential loss associated with a single item,regardlessofthetypesandamountofriskitfaces.

WhatYouShouldKnowInsurance companies profit by taking in more money in premiums

thantheypayinlosses.Theydothisbycarefully(andveryaccurately)assessingtheprobabilitythatsomethingwillhappentotheinsureditemorperson.Then theydetermine theamount that theywillhave topayandplaceavalueontheprobability.

Let’s sayyouwant to insureanexport shipmentworthUSD100,000.TheinsurancecompanyknowsthatshipmentsfromtheUnitedStatestothelocationthatyouareshippingtohavea10percentchanceofbeingdamaged,stolen,orotherwiselost.So,thecostofinsuringthesesortsofshipmentsis10percentofthepackagecost,inthiscaseUSD10,000.SotheinsurancecompanywillchargeyouUSD10,000plusanamountoverthattocovertheirothercostsofrunningtheinsurancecompanyaswellas ensuring a profit margin. Even though you’re paying USD10,000,that’s still easier than incurring the total loss of USD100,000. That’swhat makes insurance so attractive in international economics whereforeignindividualsandorganizationsoftenarenotgiventhesamerightsaslocalcitizensandpotentialdamageisgreater.Whydon’tpeoplejustinsureeverythingtheypossiblycan?Toalarge

extent,wedo.Betweenlife,health,property,auto,mail,travel,liability,malpractice, blackjack, and so many other types of insurance, it’scommon for companies and other organizations—and individuals—toinsureeveryobjecttheyown.Is all this insurance really necessary? That’s up to the individual or

organizations considering purchasing insurance. If either the potentiallossor theprobabilityofan incidentoccurring isn’tgreatenough, it isnot rational to purchase insurance. For instance, it probably isn’tprudenttopurchaseinsurancetoprotectshippingthroughtheBermudaTriangle,sincethisistoounlikelytoposeaseriousrisk.

WhyYouShouldCareA significant difference in doing business in various nations is the

degree of risk a company faces.A shipmentmay bemore likely to beattacked in Pakistan than in Switzerland. In that case, you might bemoreprone topurchase insurance fora shipmentheading forPakistanthanoneheadingforSwitzerland.AdoctorisfarmorelikelytogetsuedintheUnitedStates than inUganda,so ifanAmericandoctor joinsanNGOsuchasDoctorsWithoutBorders,she’sprobablysafeindecreasingtheamountofmalpracticecoverageshepaysfor.

56.FUTURES

Ifyou’veeverpaidanyattentiontotheinvestmentorfinancesectionofyour localnewspaper,chancesareyou’veheardof futures,even ifyoucouldn’t quite make sense of what they are. Futures are a type ofcontracttoeitherbuyorsellapredetermined quantity of a good at a price specified at the time thecontract is made. Payment for and delivery of the goods are bothperformedonthefuturedatesetinthecontract,orelsethecontractissettledincash.Many typesofcommoditiesare soldas futures, includingcorn,gold,oil, stock, bonds—anything that can be transferred in bulk withoutdifferences between units (e.g., one barrel of light crude oil does notvarysignificantlyfromthenext).

WhatYouShouldKnowFutures were originally meant to limit the transaction risk on largequantities of commodity goods by establishing terms for the futurepurchase or sale of those goods. This reduced the amount of overallvolatilityinpriceandcostoverlongerperiodsoftime.Futuresarealsonowusedasspeculationsinordertogenerateincome.Sincethevalueofgoods increases or decreases between the time the futures contract issigned and the settlement date, brokers and investors trade them atprices aboveorbelow their original valueboth to generate incomeonthe final settlement aswell as to create incomeby reselling themat aprofit.The reason the futures are so easily traded is that they arestandardized.Eachcontractoutof10,000futuresoflightcrudeoilwillbeforthesamequantityofoilpercontract,thesamequality,andsoon.

WhyYouShouldCareWhen traded internationally, futures are an effective way to limitforeign exchange risk. Thanks to their standardization, futures alloworganizationstorespondtoforeignexchangeriskincrediblyquicklyand,ifnecessary,resellthefutures.Thisabilitytoveryquicklyturncashintofuturesandviceversaiscalledliquidity;themoreliquidanassetis,themoreeasilyitcanbeturnedintocash.Thehighlevelofliquidityinherentinfuturesallowsorganizationsand

individuals to remain flexible in their risk management strategy, butwhattypesofriskaretheyhedgingagainst?Themajorityoffuturesthatrequirethedeliveryofphysicalgoodsarebasedincommodities:energy,minedgoods,agriculturalgoods,andanumberofothertypesof large-volumehomogenousassets.Thesetypesoffutureshelptohedgeagainsttransactionriskandtranslationrisk.Evenworld currencies are available for exchange in tradable futurescontracts. This decreases the amount of risk associatedwith holding aparticular currency during a time of inflationary or exchange ratedepreciation. Finally, when used to guarantee future exchanges at acurrent rate, futures can help to alleviate some of the costs associatedwithinterestrateincreases.

57.FORWARDS

The primary difference between a futures contract and a forwardscontract is standardization versus customization. Whereas futurescontractsarestandardized,makingthemeasilybought,sold,andtradedin large volumes, forwards are customized. A forwards contractgenerally has the same basic components as a futures contract; thecontractstatesthequantityandtypeofgoodstobedelivered,thepricethatwill be paid for the goods, the date of delivery, type of currencythat will be used, denomination of valuation, the exchange rate (ifapplicable), the jurisdiction for legal resolutions should conflict arise,and much more. The primary difference is that all these differentcomponentsdonotnecessarilyhavetofollowthesameterms,quantities,durations, or any other variables that would make each forwardidentical to the next. Forwards contracts, in contrast to futures, aretypicallyagreeduponbetweentwoparties,andthecontractwillremainbetween those twoparties throughout the life of the contract,withoutone side or the other selling or trading their rights to the agreement.Thisallowspeopletocustomizeforwardscontractsjustsolongasbothparties agree to the terms and the terms are legal within nations inwhicheachofthepartiesreside.

WhatYouShouldKnowIn global economics, forwards are frequently used tomake large orfrequentexchangeswhileeliminatingtheamountofriskassociatedwiththevolatilityofexchangerates.Itisverycommonfororganizationsthatarepartytolargetransactionstoagreetothetransactioninadvanceandthen execute the contract at a later date or in stages. Because of therangeofvaryingtermsinthesecontracts,itisnecessaryforthemajorityofoperatingexchanges(asopposedtoinvestingexchanges)toresorttoforwards.

WhyYouShouldCareForwardsareextremelycommonamongbusinessesthatparticipateininternational trade.Remember that such trade is not confined to largecorporations and governments; small businesses and even individualsengageinitaswell.Whenashipmentisgoingtobelargeenoughthatthe costofpurchasing the forward is less than thepotential change invalueofthegoodsbetweenthetimethattheagreementismadeandtheexchange is executed, companies generally purchase the forward. Thisprocess,more thanmost formsof riskmanagement,helpsavery largenumberofpeopleandorganizationstolimittransactionrisk.

58.OPTIONS

Asthenameimplies,optionsareatypeofexchangecontractthatgivessomeone the option to either purchase or sell their assets at apredeterminedrateandquantity.Theholderoftheoptioncandecideatany point before some future date whether he wants to exercise hisoption(meaninguseit)orletitexpire.

WhatYouShouldKnowTherearetwotypesofoptions:calloptionsandputoptions.

1. Whensomeonepurchasesacalloptionheisgiventherighttopurchaseaspecifiedquantityofgoodsatanagreed-uponpriceaslongastheoptionisexercisedbeforeitsexpirationdate.For

example,ifsomeonefromVenezuelapurchasesacalloptionon100unitsofRussiannaturalgasatapriceofRUB100perunit(RUB=Russianruble),hecanpurchaseall100unitsatapriceofRUB100atanytimebeforetheoptionexpires,nomatterwhattheactualsalepriceofRussiannaturalgasortheexchangeratebetweenRUBandVEF(VEF=Venezuelanbolivarfuerte).Ifthepriceofgasgoesup,ortheexchangerateontheRUBgoesup,theoptionholderbenefitsfromexercisingtheoptioninsteadofjustpurchasingthenaturalgas.IfthepriceofgasgoesdownortheexchangerateontheVEFgoesdown,theoptionholderwoulddobesttolettheoptionexpireandpurchasethenaturalgasatitscurrentmarketrate.

2. Aputoptiongivesthepersonwhopurchasedittheopportunitytosellhisgoodsatagivenpriceandquantity,regardlessofwhathappenstotheactualmarketpriceoftheirgoods,solongastheoptionisexercisedbeforeitexpires.Fromthetimethepersonpurchasestheputoption,shouldthemarketpriceofthegoodsgodownortheexchangeratebecomeunfavorable,theholdershouldexercisehisoptionandsellhisgoodsatthepricespecifiedintheoption.Ifthemarketpriceincreasesortheexchangeratechangesfavorably,heshouldlettheoptionexpire.

Optionsarefrequentlyusedasamethodofriskmanagementbecausethey limit theamountof increasedcostsor lost revenues.Even thoughoptionscostmoney,theamountisverysmallcomparedtothepotentialrisk,particularlyinvolatileeconomies.Theriskfactorcanbegreatevenin stable economies when dealing in goods that experience dramaticpricefluctuations,suchasnaturalresources.

WhyYouShouldCareAnyone can buy options. Banks, corporations, small businesses, andeven individuals can buy, sell, and trade options in any number ofthings.Asalreadynoted,businessescanhedgetheriskof internationaltransactions using options to limit losses resulting from variability inexchangerateandinflationarydifferentialsbetweennations.Optionsarealso frequentlyused to limit the amountof risk that individual peopleexperience when investing in stocks. Options and other investing

derivativeshavegainedareputationforbeingextremelyrisky,butthat’sreally onlywhen people use them in a riskyway.When used as theywere intended, as a riskmanagement tool, options hold nomore riskthanthepriceyoupaidtopurchaseit.

59.FOREIGNEXCHANGESWAPS

Swaps are a seemingly simple but ingenious device formitigating thepotential for transaction risk, translation risk, inconvertibility risk, andmanyother risks rooted in thepotential for currency to lose its value.Foreign exchange swaps occur when two organizations, each holdingdifferentcurrenciesbutnotnecessarilytheirprimarycurrency,agreetoexchangeanamountof thosecurrencies that theyagree tobeequal invalue.At thesametime, theyalsosigna forwardcontract toexchangethecurrenciesbackagainattermsbothpartiesagreewillbefairforthefuturevaluesofthosecurrencies(whichmaynotnecessarilybethesamerate).Thebottomlinehereisthataforeignexchangeswapmeanstwoorganizations trade currencieswith the intention of trading thembackagaininthefuture.Thefundsused inaswaparemost frequently loans,so theprincipal

and interest repayments must be taken into consideration. When twoorganizations are trading currencies in a foreign exchange swap, theytypicallytradecashflowsonboththeprincipalandtheinterestontheirrespectivecurrencies.Thismeansswapsaresubjecttointerestraterisk.

WhatYouShouldKnowThereason toparticipate in foreignexchangeswaps is tomaintaina

reserve of a foreign currency, usually for use in operations when anorganizationisexperiencingatemporaryshortageoffunds.Thatwastheoriginal purpose of foreign exchange swaps when they were officiallyintroducedbytheU.S.FederalReservein1981.Itremainstheirprimarymotivationtoday.Whenemployedtolimitrisk,swapsareusedtoaltertheproportionof

assetsheldindifferentcurrenciesoranticipateafutureneedforforeigncurrency,holdingthepotentialtolimittransactionrisk,translationrisk,

political risk, inconvertibility risk, andmore.Theycanalsobeused togenerate income when the investor anticipates changes in foreignexchangeratesandspeculatesonmovementsbyagreeingtotermsinaswaptheybelievewillbenefitthem.However,thisisrelativelyrare.Foreign exchange swaps are not the only type of swaps available.

Other types includecredit swaps,commodity swaps,andmore,but forthepurposesofriskmanagementinglobaleconomics,foreignexchangeswaps are easily the most important. Still, the most common form ofswap, the interest rate swap, can also be performed across multiplecurrencies, allowing for potential benefit in hedging risk for thoseorganizations with operations across multiple nations. Interest rateswapsalloworganizationstoexchangethecashflowsfromtheinterestratesondifferent loans,usually swapping thedifferencebetween fixedand floating rates across differentnations. Interest rate swaps can alsospanmultiplecurrencies,allowingthemtobeusedinamannersimilarto foreign exchange swaps, but focusing exclusively on the cash flowsfrominterestpayments.

WhyYouShouldCareSwapsareusedforexchangeswitharelativelyhighvalue.Unlessyou

are in charge of the finances of some company or you manage aparticularly large set of investment assets, odds are you won’t everbecome involved in a swap of any sort. The reason that organizationsshouldcareaboutswapsshouldbeobvious:ithelpsreducetheamountofrisk.Swapshavelessrelevanceforindividuals.Whenproperlyused,swapsreducetheoverallcoststhatorganizations

facebyreducingtheamountoflosswhencertainrisksarerealized.Thatmeanstheseorganizationsareeithermoreprofitable,cancharge lowerprices, orpossiblyboth. In either case, anyonewhohas a stake in thewell-being of these organizations benefits, including customers,employees,stockholders,andthecommunity.

60.BARTERS

In somecircumstances it’seasier to forgetaboutmoneyaltogetherand

just tradegoods.Thiseliminatessomeof therisksandcostsassociatedwith traditional forms of international transactions but creates otherchallenges.When a transaction takes place wherein each party to thetransactionagrees toexchangesomevalue ingoodsor services insteadofusingcurrency,thisiscalledabarterexchange.This method of exchange has varied in popularity. For a period it

became extremely popular because barter transactions were not taxedthesameastraditionalsalesinmanynations,regardlessofwhetherthecompanies generated an increase in net value. Once governmentsdiscoveredthistrickytaxtip,alltransactionsthatchangedthevalueofthe companywere treatedasgainor lossof income.Afterward,barterfelloutoffavorforanextendedperioduntilthefalloftheSovietUnionandfollowingfinancialcollapseofmanyex-Sovietstates.Foranumberofyears,particularlyinRussia,bartersbecameaverypopularoptionforbusinessesaswellasforindividualsasthenations’economiesrecoveredfromtheturmoilofthe1980sand1990s.A number of large companies operate exclusively to facilitate barter

trades between tens of billions of business transactions. Some of thesecompanies focus on retail consumer markets, including swap meets,trade centers, and the like. On an international scale, barterorganizations focus on corporations participating in much largerexchanges.

WhatYouShouldKnowBarterexchangesaretypicallyusedinmoderntimesasawaytoavoid

therisksassociatedwithtransactionrisk,inconvertibilityrisk,andsometypesofpoliticalrisk,oreventoavoidthecostsofcurrencyexchanges.Here’sanexampleofatransactionthattakesplaceinacountrywhosecurrencyisinconvertible:

CompanyA:AforeigncompanythatwantstosellelectronicstoCompanyB

CompanyB:AdomesticcompanythatwantstobuyelectronicsbuthasnothingCompanyAwants

CompanyC:CangivegoodstoCompanyAinexchangeforgoods

fromCompanyB

Assumingallthreecompaniescancometoanagreementonthevalueofexchange, thisbarterhas justbypassed theuseof currencyentirely,avoidingthoserisksinvolvedwithforeignexchangeandholdingforeignassets.Theproblemwithbartersisthattheycanbedifficulttoarrange.Since

theybecomemore commonduring timesof economicvolatility, it canbehard to calculate the exchange value of the goods to be traded.Aswell,thepartiesmusteitherbeinneedofgoodsfromeachotherortheymustbeabletofindathirdpartywillingtofacilitatetheexchange.Themorepartiesthatenterintotheagreement,themorecomplicateditistoworkoutthedetailsofthecontract.

WhyYouShouldCareBarterspresentavaluablealternativetotraditionalformsofexchange.

Particularly for the huge percentage of nations that have volatilecurrencies,bartercanmaketradepossiblewhilemanaging fluctuationsinproductionortheexchangerate.It is thisveryusefulness for limitingriskduringperiodsofeconomic

volatility that has increased the barter trade to $10 billion in 2008,accordingtotheInternationalReciprocalTradeAssociation(agoverningbody for international barter systems). This is despite transaction feesthatcanreachashighas15percent.Thatmanycompaniesarewillingtopaythesefeesmeanstheyfinditextremelybeneficialtoparticipateinbarter. After all, a sale worth EUR1 million is only valuable if onereceivesthemoneyinamannerthatisusable.Since thosenations that have a highpercentage of barter trades are

more likely to be those with very low production costs (given that ahighly volatile economy often contributes to low production and highunemployment),participatinginabartersystemcanalsohelpopenthedoor into nations with high advantages in labor costs but whichsometimes don’t have use for their own currency. For instance, inGermanybetweenWorldWarIandWorldWarIIitwasnotuncommonforworkerstoasktobepaidinfoodratherthaninmoney.Inflationwassohighthatthemoneywouldnotpurchaseasmuchfoodbytheevening

as it had in the morning. In such cases, barter can be tremendouslybeneficial not only for maintaining good trade relationships betweenorganizations, but also for increasing economic stability within thenationitself.

CHAPTER7ForeignInvestment

Recall from Chapter 3 that there are two sides to every exchangeinvolved in international economics: the transition of goods and thetransition of the ownership of capital. We’ve talked a lot about theexchangeofgoods,butmuchofthefocusoncapitalhasbeenmerelyoncurrency.Sure, themajorityofcapitalexchangesthattakeplaceare incurrency,andwe’vealreadyestablishedthatthewillingnesstoexchangeone’s goods and services for another nation’s currency is a form ofinvestmentwith theexpectation that the foreignnation’s currencywillmaintain or increase its value in the future. Even so, this is only oneformofforeigninvestment.Themajorityof foreign investments canbedivided into twoclasses:

businessinvestmentsandfinancialinvestments.

1. Businessinvestmentsrefertothedegreetowhichanorganization(usuallyabusiness,butnotnecessarily)integratesitselfintoaforeignnation,especiallyinthesourcingofcapitalandtheamountofdirectinvolvementwiththeforeignnation(asopposedtoworkingthroughpartnersorthroughimport/export).

2. Financialinvestmentsworkquitesimilarlytostandardfinancialinvestments(i.e.stocks,bonds,portfolioanalysis,etc.)butwithafewaddedtwiststhatcomewiththeadditionalcomplexitiesassociatedwithtransnationalcapitalexchanges.

61.FOREIGNDIRECTINVESTMENT

Foreigndirectinvestment(FDI)ismadebyanorganizationorperson

from one nation into a foreign nation’s economic production. It eitherestablishesnewoperationsinthatnationorpurchasesadirectshareinsome operations that already existwithin the foreign nation’s borders.Thesearenotinvestmentsinthewayyou’reusedtothem—say,throughpurchasingstock.TheintentofFDIisnottosimplyinvestinthefinancesofaforeigncompany,buttoinvestinitsoperationsandhavearoleinthe production and management of that organization. It is a way fororganizationsandentrepreneurs toexpand theiroperationsbeyond thebordersoftheirhomenation.FDI comes in awidevarietyof forms, eachwith its own setofprosandcons.Generallyspeaking,theprimarydifferenceamongthemisthedegreetowhichtheinvestoriscommittingherselfandherorganizationto the foreignnation’sproduction. It’spossible tohaveapresence inaforeignnationwithoutactuallyeverhavingofficialoperationsthere.Asa rule, the more direct involvement and ownership one has in theforeignexpansioninvestment, themoreonehasanincreaseddegreeofcontrolandabilitytoremainresponsive.Thatalsocomeswithadditionalcostsandrisksassociatedwiththecomplexityofoperatinginaforeignnation (not to mention operating in at least two nations—the homenationandthehostnation—atonce).

WhatYouShouldKnowThere’sanoldsaying:“Noguts,noglory.”Ifyoutaketheadditionalrisk inyour investments,youshouldexpectadditionalreturns. It’s truethat, keeping everything else equal, if an investment has higher risk,peoplewillexpectmorebenefits,butthatdoesn’tmeanthey’regoingtogetthem.Therehastobesomethingtheretomakethembelievethattheinvestment will be successful. During the 1990s and 2000s, manycompaniesattemptedtoexpandtheiroperationsintoChinathinkingthatbecause there were so many people in China their investment wasdestined for success.They thought to themselves, “Well, there’s risk inthis investment butChina is so big that therewill be a hugepayout!”They were wrong and they paid for their recklessness. On the otherhand,thosecompaniesthatactuallyresearchedtheChinesemarketandmeasuredtheirriskandpotentialreturns,investingresponsiblyandwithprudent risk management, were able to generate the benefits they

sought.

WhyYouShouldCareOnce you’ve performed your proper research and developed anunderstanding of the risk and expected returns of an investment, theactual process of FDI is quite simple.Often it’s nomore complex thanstarting a business in your home nation; there’s a bit of paperworkinvolved, you have to run around to various government agenciesregarding permits and registration, and it can sometimes take a bitlonger than you’d like, but the process itself isn’t really that muchdifferent.Insomecasesitdoesn’teventakethatmuch;youjusthavetolookupwhetherornotthereareanytraderestrictionsbetweenyourtwonationsfortheparticulargoodsinquestion,andthat’stypicallyavailableon the Internet or can be found with a single call to your nationalcustomsagency.Thepoint is that foreigndirect investment is not necessarily a largeandexpensiveprocessavailableonlytothelargestorganizationsintheworld.Anyschmuckwithabitofmanagementexperiencecandoit.ThedifficultpartofFDIisthesamepartthat’sdifficultinanybusiness:theprocessofrunningthebusinessitself.

62.IMPORTSANDEXPORTS

Themostbasic,easiest,andleastriskymethodofinvestingintheglobaleconomythroughFDIistoimportandexport.Despitewidespreaduseoftheseterms,peopleoftenfeelintimidatedbytheideaofparticipatingininternational trade. Importing and exporting is simple and, in fact,there’s a good chance that you’ve already participated in one suchtransaction.Exporting,initssimplestform,consistsofputtingsomethinginabox,taking it to the post office, and mailing it directly to the purchaser.Importing is even easier, since it only involves going to somewebsite,ordering a product, and waiting for it to arrive. Even determiningwhether there is some law or tax placed on imports and exports is asimplematter; you need to call whatever agency is in charge of such

mattersandaskthemtheprocessforreportingthetrade.As an example of a company that does importing and exporting to

anothernationwithoutactuallymaintaininga foreignoperation in thenations they are dealing with, I turn to my alma mater, MadonnaUniversity. Their school of business has an online option, so they canprovide services to foreign students without actually having anyoperationslocatedabroad.Itisanexportofservices.

WhatYouShouldKnowThe willingness to export to customers overseas or to import from

other nations isn’t in itself a foreign investment. With simple importsand exports, the investment really comes in the form of marketing,research,andotherwisemakingtheconnectionsrequiredtomakeyourefforts in trade viable. There is an additional degree of difficultyinvolved inmanaging internationaloperations for importsandexports;youhavetodevelopbranding,advertising,distribution,andotherformsofmarketing,andbecauseyouaresofarawayyoumusthandleallthatvirtually—by phone, Internet, letter, or representative. Importing ismuch easier; you just have tomake sure you’re getting the best pricepossiblefromallthosepotentialsuppliersaroundtheworld.Importingandexportinghave the lowest riskof any formof foreign

direct investment, the lowest costs associated with internationalexpansion, and still have value not only in decreasing costs andincreasingyourmarketsizebutalsoinestablishingapresenceinforeignnations.Inordertostrengthenyourpresenceinaforeignnationandtomanageyourcompanyasaprimarymarketchoicecompetingwithlocalfirms,orwhenanexporterisoneofyourprimarysuppliers,you’llneedstrongerformsofFDI.Still,importandexportisaformofinternationalinvestmentthatevenself-employedindividualscanafford.

WhyYouShouldCareOdds are a very large percentage of everything you purchase in a

givenyearisimportedfromanothernation,inwholeorinpart.Atthesametime,atleastaportionofwhateveryoudoforworkcontributestothevalueorfacilitationofsomeexport.WiththeadventoftheInternet,globalmarketingandsaleshavebecomeeasierthanever,andexpanding

yourselforyourbusinessinternationallycanleadtoadramaticincreaseinthefinancialandoperatingefficiencyoftheorganization.Forpeopleandbusinesses searching for cheaperalternatives thanwhat’savailabledomestically, importing is an availableoption that is nomoredifficultthan searching the Internet. For larger volumes, more valuableshipments, andcontinuousneed, itmightbehelpful to contact foreignsuppliersdirectlyormeetwithforeignconsultingfirmsthatspecializeinforeignmarketanalysis.Forproducersor retailers, sellingdomesticallyis no longer even a requirement if they can establish a large enoughInternetpresence.Directadvertisingabroadcanestablishone’scompanyquitewellwithinthemarket.

63.PARTNERSHIPSANDJOINTVENTURES

When two or more people own a single organization that is notincorporated—itdoesn’tmatterifeachownsanequalshareornot—it’scalled apartnership.Apartnership either forms aneworganizationorelseitturnsanonpartnershiporganizationintoapartnership.Partnerships, in global economics, usually refer to organizations inwhichatleastonepartnerholdsresidenceinadifferentnation.Itdoesnottypicallyrefertoascenariowhereanorganization,establishedasapartnership between people all living in the same nation, attempts toexpandintoadifferentnation;that’sconsideredawhollyforeignownedenterprise.Developing a foreign partnership is often seen as the next level offoreigndirectinvestment.Byenteringintoapartnershipyoucommittoonlypartialownershipofaforeigncompany.Thatstillinvolvesagreaterdegree of involvement and association with that foreign nation’seconomicoperations. Itdoesnot involve integrationwithother foreignorganizationsanddoesnotrequireyoutoaccepttheentiretyoftheriskinvolved in developing the foreign enterprise. The upshot is thatpartnershipsarestillsaferthansomeotherformsofFDI.Joint ventures are similar to partnerships, except that instead of

individualpeople,oneorbothofthepartnersareorganizations.

WhatYouShouldKnowInglobal economics, partnerships areuseful for a few reasons. First,

going into business with a foreigner who is already familiar with theforeign market, culture, and business environment can be invaluable,especiallyifyou’renotalreadyfamiliarwiththoseyourself.Ontheotherhand,teamingwithsomeonewhohasbusinessorindustryexpertiseoriswillingtoprovidefundingcanalsobehelpful.Somegovernmentsdonotallow foreigners toownbusinesseswithin

theirnation,orrestrict foreignownership inaparticular industry.Thiscanbeovercomebyenteringintoapartnershipwithalocalpartner.Developing a foreign partnership does, however, present some risk.

You should be particularly careful in choosing your partner and inestablishingthecontractualdetailsofyourrelationship.Hiringalawyerwhospecializesinthelawsandlegalsystemofthenationinwhichthepartnership will be established is highly recommended. One commonwaytodevelopapartnershipinaforeignnationistopurchaseorinvestin a share of an already existing foreign company (noncorporation, ofcourse).Thiscanhelptotakesomeoftheuncertaintyoutofthestartupprocess and assistwithmanyof the questions about the credentials ofyourpotentialpartners.

WhyYouShouldCareForeign partnerships afford certain benefits over a simple

import/export operation.Maintaining a presence in the foreign nationallowsthecompanytobemoreresponsivetochangesinthemarketandbetter manage the operations related to the foreign competition.Partnerships, as one enters into a foreign nation, integrate theorganization more fully while still allowing the foreign partners tomitigatetheriskofcompletelyintegratingintoanationnottheirown.Note that both partnerships and joint ventures usually extend to all

forms of organizations (although partnerships where one partner is acorporationtendtobeexceedinglyrare).

64.MERGERSANDACQUISITIONS

A merger occurs when two organizations combine to form a single,largerorganization.Anacquisition is similar,except thatonecompanyactuallypurchasestheother,givingonecompanytotalcontrolovertheother.Expandingoperations throughmergersandacquisitions (M&A)helps

to takea lotof theuncertaintyandriskoutofFDI,which iswhytheyaresopopular.Bymergingwithoracquiringanotherorganizationthathas already established its operations in a foreign nation, it is verysimple to determinewhether that company has been successful in thepast and whether their competencies and operations will complementthose of the acquiring organization. Since the company is alreadyestablished, that also eliminates a lot of the risk and uncertaintyassociated with a startup, since the organization has already gonethrough the legal hurdles, developed a customer base and distributionchannels, and is recognized by the nation in which it operates. Thatallows foreign companies, through the use of M&A, to expandinternationallywhileminimizingrisk.

WhatYouShouldKnowMergers and acquisitions are confined to large companies, at least

whentheyinvolveinternationalcompanies.Itcanbeaveryexpensive,difficult,andlongprocessevenwithinasinglenation(itshouldcomeasno surprise that buying an already successful company is not cheap),withouttheaddedcomplicationsofperformingsuchtransactionsacrossmultiplenations.So,whilemuchoftheriskassociatedwithastartupiseliminated,organizationstakeonthosedifferentriskswhenengagedinan M&A deal. That includes uncertainty about management andcorporate culture (employee turnover inM&A companies is often veryhigh),complementaryoperations(thingsmaynotworkasyou’dhoped),brandingandproductlines(theymaycannibalizeeachother),andeventhe true value of the company being acquired. To be blunt, if youwouldn’tmergewith a companywhen itwas operating in your homenation,whyshouldyoumergewithitoverseas?

WhyYouShouldCareThe1980smarkedthepointwhentheuseofM&Aasaninternationalexpansion strategy gained popularity. The influence these exchangeshave on the global economy can be far reaching, as both companiesrearrange their operations, strategies, and resources. Jobs frequentlychangelocationorimportance;assetschangelocation;operationswithinthe organization are rearranged; purchases that the company makeschange; and their sales demographics change. A singleM&A deal candramaticallychangethetradeandassetmovementbetweentwonations.The larger the companies party to an internationalM&A deal are, themore those two nations have become increasingly economicallyintegrated. As more companies own one another across borders, themore integrated do those nations become as a result of the economiccodependencecausedbytheshareofownershipeachhasintheother’seconomy.

65.WHOLLYFOREIGNOWNEDENTERPRISE

The decision to open a wholly foreign owned enterprise, orWFOE, isabout as big a commitment to the economy of a foreign nation as anorganizationcanmake.Awhollyforeignownedenterpriseisacompany,division,orbranchthatislocatedinonenationbutisentirelyownedbyanorganization, individual,or setofpartnerswhoclaimcitizenship inanother nation.Unlike other forms of organizations, aWFOEdoes notshareownershiporcontrolof theorganizationwithanyforeignentity,even those that reside in the nation in which the WFOE is beingestablished. Instead, the investors have decided that they’re savvyenough to take on the challenge of expanding internationally on theirown andwill assume all the risk aswell as all the rewards associatedwith the investment.To summarize,aWFOE isanorganization inonenation,ownedbyanothernation.There are anumber of benefits associatedwith aWFOE,mainly theincreased control and strategic consistency, as opposed to those ofpartnerships or mergers. In contrast to import/export, establishing a

WFOE allows an organization to much more closely manage theorganization’srolewithintheforeignnation.WFOEstendtobeeasiertocreateanddissolvethanpartnershipsandventures.Morethananyotherform of FDI, starting aWFOE allows nations to keep their operationsprivate,morecloselymanagetheirdistributionchannels,andotherwiseprotect their company and products from copyright infringement orcorporate espionage. It is for these reasons that theWFOE is probablythemostcommonformofFDI.That’s not to say aWFOE is all great, either. There is a substantialdegreeofrisk involvedanytimeanorganizationtriestoexpandintoaforeignnation.Anyonewhodoesthisshouldhireforeignnationalsatalllevelsofmanagementandoperations.Manygovernmentsrequirethataminimumpercentof the labor forcebe citizensof thenation inwhichtheWFOEwasestablished.

WhatYouShouldKnowThemajority of foreigndirect investment ismadeup ofWFOE-styleorganizations.Eachonefacesissuesthatareoftenuniquetoitsindustry,butthereareanumberofconcernsthatallWFOEcompaniesencounter.We’ve already talked about the legal restraints that some nationsimplement,aswellasfamiliaritywiththelocalcommunity.Theconceptof guanxi in China, for example, means that people rely heavily onpersonalrelationshipsfortheirbusinessdecisions.It’salittlebitliketheold saying, “It’s notwhat youknow, it’swhoyouknow thatmatters,”exceptguanxiismoredeeplyingrainedwithinChineseculture.

WhyYouShouldCareDespite the challenges that comewith starting aWFOE, this is stillwellwithinthecapabilitiesofthevastmajorityofpeople.Ittakesabitmore timeandeffort,but ifyoustart it likeyou’re startingabusiness,you should be fine. Assess every detail of the foreign nation and itsculture; assess the market for your organization; build a brand newbusiness plan and marketing plan; and make sure you study thosedistinct issues foundonly inglobaleconomics suchas thedynamicsofcurrency movements, tax and interest differentials, and capitalmovementandtradelaws.

66.FINANCIALINVESTMENT

In contrast to foreign direct investment, companies make financialinvestmentswithout intending tobecome involved in theoperationsofthe company. Financial investors may purchase debt, equity, or anumber of other potential products that provide funding for a foreigncompanytouseforstartupcosts,expansion,orstandardoperations,butthese investors are given no actual role in the management of theorganization; their role is to provide financing in return for a futurestakeintheorganization’sprofitability.Therearefourprimaryformsoffinancialinvestment:

1. Debt

2. Equity

3. Commodities

4. Derivatives

There are other options available, but, particularly for foreigninvestment, theseareeasilythemost frequentlyused.Sincederivativesarediscussedinthisbookinthechapteronriskmanagement,we’llskipover that and instead focus on equity, commodities, and debtinvestments.Allthreeareissuedwiththeintentofprovidingfundingforan organization (governments, companies, etc.) and are frequentlytradedinmarkets.Thepersonmakingtheinvestmentwantstogetbackmore money than they invested. As we already discussed, theexpectation of return is also accompanied by risk. The exact nature ofthatriskdependsontheinvestment.

WhatYouShouldKnow

1. Equitiesaresharesofownershipinanorganization—essentiallythisisafancynameforstock.Aswithallstockshares,yourgoalasaninvestoristoeitherreapdividendsbasedonthecompany’sprofits,orsellthestocktoanotherinvestoratahigherpricethanyoupaidforit.Equitiescarrysomerisk—ratherthanriseinvalue,theymay

fall.

2. Debtinvestmentmaysoundalittleoddtosome.Ifyou’veeverbeenindebt,imaginethatdebtfromtheperspectiveofthepersonwhogaveyouthemoney;forthemit’saninvestmentbecausetheywillgetbackmoremoneythantheygaveyouthankstothemagicofinterestrates.Mostdebtinvestmentsaretradedintheformofbonds,whichoftenyieldinterestpaymentsatregularintervals,andalwaysincreaseinnominalvalueafterthematuritydateofthebond.Atthispointitcanbeexchangedforthehighervalueratherthanthevaluepaidforit.Again,therearerisksassociatedwiththesesuchasinterestraterisk,defaultrisk(wheretheorganizationgoesbankrupt),orinflationaryrisk.Debtinvestmentscanalsobetradedonamarketlikestocks,boughtandresoldataprofit.

3. Commodityinvestingworksinasimilarwaytostocks,exceptyou’repurchasinganownershipintheproductionofaparticularvolumeofgoods.Let’ssaythatPeruhasacropofpotatoesreadytobeharvestedinsixmonths.Youwanttolockinyourprice,soyoupurchaseownershipoffivetonsofpotatoesnow.Youcanbuy,sell,andtradesharesofthisownershipuntilthedateofdeliveryforthepotatoes.Thenyouexchangeyourcommoditiesforthepotatoesthemselves,orforthedifferenceincash.

WhyYouShouldCareInvestinginthesedifferentfinancialinvestmentsinternationallyisnot

so different from doing it domestically. Expanding your investmentsinternationally,though,canveryquicklyincreasethecomplexityofyourinvesting strategy.Thereareanumberofbenefits fromdiversification,widening your pool of potential investments (or, if you’re with anorganization,wideningyourpoolofpotentialinvestors),andimprovingthe prospects for finding growth investments. There are also uniquerisks.With improved technology, international trades in investments can

easily occur from any place on the planet. And, not surprisingly, it’sbecomecommonplace.

67.INTERNATIONALDIVERSIFICATION

Forbothinvestorsandbusinesses,expandinginternationallyisaboutfarmorethansimplytryingtogeneratemoreincome—it’saboutminimizingrisk for the business that can result from economic volatility, seasonalfluctuations, and domestic variations in demand and price. Nomatterhow well an investor spreads out his assets or how well a companydiversifies itsproduct lineand targetmarkets, there’s still the risk thattheeconomywillexperienceageneralizedlossofvalue,arecession,orcontraction. This is called market risk, and many believe it can’t beminimized through diversification. On the other hand, not all nationsexperienceeconomicfluctuationsatthesametimeoreveninthesamedirection. As a result, when an investor or company expandsinternationally, they are doingmore than seeking outmore customersandcheapersuppliers;theyareseekingoutinvestmentopportunitiesinnations thatwill experienceeconomiccyclesdifferent from theirhomenation.

WhatYouShouldKnowThesuccessofinternationalportfoliodiversificationcanbemeasured

withseveralinstruments:

1. Beta.Thismeasureshowfarfromthelargernationalmarketyourowninvestmentsdeviate.Inotherwords,ifthemarketincreases10percentandyourportfolioincreases10percent,thenyourbetais0.Ifyourportfolioincreasesbyeither2percentor18percent,yourbetawillbeeitherhighorlow.Betaisn’tameasureofvolatility;itmeasuresonlyhowfarfromaverageaparticularinvestmentorportfoliostrays.

2. Rf.Thisreferstotherateofreturnonrisk-freeinvestments(rememberthatfromthechapteraboutrisk?).Investorswanttoexceedthisrateofreturn,regardlessofwhetherthey’reinvestinginFDIorfinancialinvestments.

3. Rp.Thisreferstotherateofreturnonacompany’sproductportfoliooraninvestor’sinvestmentportfolio.Thisistherateofreturnthey

areactuallyexperiencing.Itshouldnotonlyexceedtherateofreturnonrisk-freeinvestmentsbutalsobehighenoughtomaketheriskworththedifferentialintherateofreturn.

4. Risk.Thereareavarietyofdifferentwaystomeasurerisk,andjustabouteveryfinancialexpertandeconomisthastheirownway,somebetterthanothers.Theriskoflossisnotjustvolatility,asmeasuredinbeta,buttheriskofyouroperationsorinvestmentsactuallylosinglong-termvalueorfailingcompletely.

There is one thing that I have tomake clear: Diversification cannotlimit therisksassociatedwithbeingstupid. Itwon’tsaveyoufromtheconsequencesofpoordecisions.Ifyouknowthatsomeinvestmentsarebetter than others, construct your portfolio accordingly. Diversifyingyourmarketorinvestmentportfoliosimplyforthesakeofdiversificationwill result in unnecessary inefficiencies. Look at the best optionsavailable for expanding your portfolio andmake the best choices youcan.

WhyYouShouldCareDiversification is important for everyone active in the market.

Investorscanincreasetheirreturnsbyusinginternationaldiversificationto limit the risk of a single investment losing value. Companies canbenefit from international diversification by limiting the impact ofgeneralized national economic fluctuations, seasonal fluctuations, andthe potential for sudden drops in demand for a particular sector orproduct. However, even though international diversification candecreasevolatilityandcertainformsofrisk, it isnotareplacementforknowingwhatyou’redoing.

68.EUROBONDS

EurobondsdonotnecessarilyhaveanythingtodowithEurope.Rather,they’re bonds held in one nation and subject to its interest rates, butdenominated in a currency other than the primary currency of thatnation. So, for example, a bond that is issued by banks out of the

exchange market in Bahrain but is denominated in Japanese yen andheldbyacitizenofMoroccowouldbeconsideredaEurobondregardlessofthefactthatithasnoconnectiontoEurope.Eurobonds are named after the currency in which they are

denominated.Forinstance,aEuroyenbondisaEurobonddenominatedinJapaneseyen;aEurodollarbondisaEurobonddenominatedinU.S.dollars.Eachofthesebondscanbeissuedanywhereintheworldotherthan the nation that uses the currency in which the bond isdenominated.

WhatYouShouldKnowFromtheperspectiveoftheorganizationissuingthebonds,Eurobonds

offer flexibility. They allow organizations to maintain their debtvaluationsinasinglecurrency.Thisnotonlyhelpsreducetheamountofrisk associated with exchange rate fluctuations but also simplifiesoperationsforthosecompaniesthatdon’ttypicallyuseothercurrenciesorthatarelookingtoavoidtransactionrisk.Thisalsohelpstowidenthepoolofpotentialinvestors,makingiteasiertoattractinvestorsatlowercostsassociatedwithyieldandinterestrates.Forinvestors,Eurobondsoftenhavesmallerparvalues—orfacevalues

—than other forms of larger international investments, making themavailabletoawiderrangeofinvestors.Theyallowinvestorstospeculateonexchangeratefluctuationsinadditiontotheinterestgeneratedfromthebonditself.

WhyYouShouldCareTheEurobondisaninvestingproductthatisuniquelytheproductof

theglobaleconomiccommunity;it’sacombinationoftraditionalbondsandcurrencydifferentials,intendedforglobalavailability.Globalizationisproducinginnovationinsomenewandinterestingareas,andtherearelikely to be more such products in the future. As for the bondsthemselves, they provide a method for investors to speculate on theexchange rate market while mitigating the risk of loss, thanks to thereturns experienced in interest rate yields, and without necessarilymakinginvestmentsofgiganticvolume.Inotherwords,Eurobondsmakethe foreign exchange market more accessible to a wider range of

investors.

69.SOURCINGCAPITALGLOBALLY

Asorganizationsareintegratedmorefullyintoforeignnationsandtheirrespective investment markets, as well as the fully internationalinvestmentmarket,moreoptionsbecomeavailabletosourcecapital.Thevastmajorityofbusinessesintheworlddonotnecessarilyneedaccesstosomanydifferentmarkets tosourcethecapital theyneed.Still, there’snoreasonthateventhesmallestcompaniesshouldsimplyaccepthighercosts associated with sourcing capital domestically when with a littleresearch they might find that they can achieve their goals moreefficiently.Companies that have been successful on a domestic stock marketsometimes think that the next logical step is jumping into a foreignmarket.Thiscouldn’tbefurther fromthetruth.Thereareanumberofintermediary steps that integrate a company into the foreign globalcapitalpools.

WhatYouShouldKnowNoone likes toplayguessinggameswhen itcomes to largesumsofmoney. The best option when exploring the possibilities for theinternational sourcingofcapital is to start slowlyandevaluateeachofthesteps,aswellasdiscussaplanwithaprofessionalfamiliarwiththemarkets. Here are a few of the most common steps taken byorganizations in theirpursuitofmoreor cheaper sourcesof capital, inorderfromleastglobaltomostglobalinnature.

InternationalBondIssue.Theeasiestwaytobeginexposingone’sorganizationtotheinternationalcapitalmarketistoissuebondsinforeignnationsorontheinternationalmarkets.Thismethodhasthelowestdegreeofcomplexity,ischeap,easy,andjustaboutanyonecandoit.

EurobondIssue.Thenextstep—alittlemorecomplexbecauseofthenatureofthecontractsandthescarcityofbondmarkets

participating—isEurobonds.Thecurrencydenominationissuemakesthesebondsalittlemorecomplicatedthanstandardinternationalbonds,butthey’rewellwithinthegraspofevenmanysmallbusinesses.

Cross-Listing.Cross-listingmeansthatasinglecompanyhasdecidedtomakeitsstockavailableinmultiplenations’stockmarkets.Thisisthefirststepinexpandingone’sstockmarketpotential,inordertogarnerawarenessandperformancemeasuresinforeignmarketswithoutriskingdrivingdownthedomesticshareprice.

ForeignIssue.Ifthereisenoughdemandforyourcompany’sstock,thenactuallyissuingsharesinaforeigncountrycanhelpraisesignificantcapitaland,ifyou’relucky,evendriveupsharepricesinyouroriginalnationoflisting.

EuroequityIssue.Trulythemostintegrated,mostpromising,butmostdifficulttoattemptofallthemethodsofsourcingcapitalistheissueofeuroequity.Aeuroequityissueisoneinwhichacompanyholdsaninitialpublicofferingthatisavailableinmultiplenationssimultaneously.Investorsaroundtheworldfightforthesamesetofstockshares,makingforacompetitivemarket.

WhyYouShouldCareEven the largest companies,whenexpanding their search for capitalinternationally, will use investment bankers. It’s not somuch that theprocessitselfisverydifficult,butplanningthebestoptionsavailabletoyou andhow tomaximize your availability of low-cost capitalwill gobestifyoumakeuseofapersonfamiliarwiththeinternationalmarkets.Once the plan is set, the company should make an assessmentregardingthecostsofsourcingcapitalpurelydomesticallycomparedtosourcing capital internationally. The difference in the cost of sourcingthatcapitalmeansanimprovementinyourtotalfinancialperformance,whichcanmakeasignificantdifferenceinwhetheryourorganizationiscompetitiveornot.

70.INTERNATIONALPORTFOLIOOPTIMIZATION

Diversification, which we talked about previously, applies to foreigndirectinvestmentaswellasfinancialinvestment.Inadditiontochoosingthebest companies to include in theirportfolio, investorshave severalother ways to optimize the returns on their investments. Generallyspeaking,as theamountof risk increasesso toodotheratesof return.Normally, inadomesticmarketan investor can investmoreandmoreuntil therateofriskbeginstoincreasefasterthantheexpectedrateofreturn.These investments, in volume,will eitherbegin topushup thepriceofindividualinvestments,reducingtherateofreturnexperiencedforeachadditionalunitofinvestment,ortheinvestorwillhavetobegindiversifying into investments that generate lower returns than thebestpossiblechoice.Inordertooptimizetheportfolioinadomesticmarket,then,aninvestormustcontinuetoaddtoherriskyinvestmentsuntilthepoint that thebest investmentshecanchoose increasesriskmore thantheexpectedrateofreturn.Atthatpoint,she’llchoosetoinvest intherisk-freeoptionsinstead.Internationaloptimizationchangesthepotentialdynamicbetweenriskandreturnsinseveralimportantways.Inadditiontothediversificationalreadytouchedoninthischapter,thereareothervariables:Thenationthat an investor chooses, the relative changes in growth betweennations, the currencies that each nation uses, and even the level ofeconomicinterdependencebetweennationsallplaysignificantroles.

WhatYouShouldKnowIn an international investment market, the increase in investmentoptions greatly increases the potential for a portfolio. There aremorecompanies available, many representing better investing options thanthe secondor thirdbestoptionsavailable in thedomesticeconomy. Inaddition, the greater volume of investments available means investorscan allocate a greater amount of assets to those best options withoutinfluencing price and, as a result, the rate of return. This means thatinvestorscangeneratemuchhigherreturnsbeforeriskbeginsexceedingtherateofreturn,reducingtheneedforrelianceonrisk-freeassets.In international investing it’s critical to be knowledgeable about thenations in question. Investors often are attracted to “emergingmarkets”—code for developing nations. Since these countries tend to

have economies that grow faster overall than developed nations, it’sassumed that any successful company in a developing nationmust bedestinedforanamazingfuture.Toacertainextent,that’strue.Investorswho can pick out which nations are growing the fastest in a stablemanner,andthenpickoutthebestcompaniesinthosenations,willreapbenefitsnotonlyfromthecompanybutalsofromgeneralizedeconomicgrowth.Manycountriesarehighlyinterconnected,however,andsopartofthetrickisdetermininghowwelltheeconomiesoftwonationsmatcheach other. Economic influences are not just domestic anymore; theperformancesofinvestmentsaroundtheworldareoftentimesalllinkedtothesamevariables.

WhyYouShouldCareAsyoumightimagine,internationalinvestmentportfoliomanagementcanbeaverycomplicatedissueifoneallowsittobe.Everyinvestorhashisownmethodandapproach to investing, somemore successful thanothers.Whether you’re amath dork likeme, a behavioral analyst, anexperienced business tycoon, or just a lucky guesser, you’re still onlytryingtofigureoutthebestvalueamongaseriesofvariables:company,country, and currency. That puts international investing well withinreachofanyonethathassomeextracashintheirpocket.

71.GLOBALCOSTOFCAPITAL

Expandinginvestmentsandinvestinginternationallyisn’tjustbeneficialfor investors; it does a lot to help the organizations raising capital byissuingtheinvestmentsinthefirstplace.Allorganizationshavetodealwith the costs of raising capital. Investors aren’t going to simply givemoneyawaytoorganizationswithoutsomeexpectationsofabenefit;thebenefit investors receive is, from theperspectiveof theorganization,acost. In the case of bonds, this cost comes in the formof interest andyields,whileforequityitcomesintheformofdividends.Whenacompanyissuesequityordebtinvestmentsaroundtheworld,oratleastinoneadditionalnation,itisdecreasingthecostsassociatedwith raising capital. This occurs because the company has broadened

and expanded itsmarket for potential investors. The increasedvolumeandvarietyofpotentialinvestorsallowthecompanytoattractanequalamountofcapitalmorecheaplythanwouldotherwisebepossible,ortoattractmorecapitalthanwouldotherwisebepossibleforanequivalentcost.

WhatYouShouldKnowThe potential for the cost of capital to decrease as a result of the

internationalexpansionofcapital sourcingdependsgreatlyonthe firmitself.It’suptothecompanytoextractcapitalfromthoseinternationalinvestingmarketsatalowercostthandomesticones.Therealquestionlies in the rateof return that a companywill be able togenerate. If acompanypursuesahigherbudgetassociatedwithinternationalprojects,itwill need to raise a larger amountof capital. It’ll costmore to raisethiscapitalthanitwouldifthecompanywereengagedonlyindomesticprojects. In short, there’s a tradeoff between raising capitalinternationallyandmaintainingastrongreturnoninvestment.

WhyYouShouldCareLower costs and improved returns for firms translate into more

efficientresourceusage.Thisgenerateseitherhigherinvestmentreturnsfor shareholdersor lowercosts forconsumers—somethingwe’dall liketosee.

CHAPTER8MovementofCapital

This chapter deals with the most fundamental forces in globaleconomics.Aseconomicsisasciencethatstudieshowpeopledistributealimitedsupplyofresources,globaleconomicsis,atitsheart,thestudyofhowthoseresourcestravelaroundtheworld.Whendiscussing themovementofcapital,we’renot just referring to

transporting goods back and forth. Throughout this chapter we willdiscuss how cities are born and reborn, how people migrate acrossborders both natural and artificial, the influences onwhere we locatedifferenttypesof thingsanddifferenttypesofpeople,andthe logisticsofhowitallhappens.

72.TRADEGRAVITY

Inthevacuumofouterspace,thankstogravity,objectsthatfloataroundwillbeattractedtoeachother—evenverysmallobjects.Everyobjectintheuniverseexertssomegravitationalpull.Asthesetinyobjectsclingtoeach other to become a single object, the gravity of this aggregatedobject increases, attracting even more matter. This is how the starsoriginally formed—astronomical amounts of hydrogen gas clusteredtogether in clumps so massive that the hydrogen atoms were forcedtogether,makingheliumaswellasotherheavierelements that formedplanetsandevenpeople.AsthelateastronomerCarlSagansaid,“Weareallmadeofstarstuff.”The same kinds of processes that formed our universe also created

cities; they are the basis for amethodofmeasuring capitalmovementcalledtradegravity.

Everyindividualhastheabilitytoattracttrade,inthesamewaythatevery molecule has the ability to attract other molecules. This is our“gravity.”Anypersonwhocanproducemoregoods than theywillusecan trade their surplus for other goods.When twoormorepeople areproducingmoretogetherthantheycouldbythemselves,theyhaveevengreatergravitybecausetheyarenowproducingevenmoresurplusgoodsthantheyneed.Asthequantityofgoodsbeingtradedandthequalityoflife increases in the area as a result of trade, other people will beattracted to the center of trade. These people move around the traderegion, entering and leaving it, just as the molecules within a starinteractwitheachother.The interaction of hydrogen molecules in a star produces heavierelements, most of which are eventually expelled from the star. In thesame way, the interaction of individuals in a trade region producesgoods and services, which are eventually all pushed outward. Just asstarsdiebysheddingtheirgases,citiesshedalltheirwealthandassetsfrom the middle, forming ghettos, blight, and becoming decayedversionsoftheirformerselves.Tradegravityisameasureofthedegreetowhichaneconomicmass,usually a city,will attract trade from other parts of the globe. As theeconomicmass increases, trade gravity also increases, attractingmoretrade. For example, New York City has more economic mass thanYellowknife,Canada,andasaresult,attractsmoretrade.Economicmassis measured by GDP, which is an imperfect but reasonably usefulmeasureforourpurposes.

WhatYouShouldKnowThe trade gravity between two locations is measured by using theequation

Put simply, as two locations have larger economic mass, they willattractmoretradetoeachother,butthedistancebetweenthemwillalsoinfluence the amount of trade. More distant locations will experiencelesstradethancloserlocationsofequaleconomicmass,althoughthisisbecominglessrelevantwithincreasedglobalization.Ofcourse,thisisasimplified model. More complex models have proven accurate inpredicting trade aswell as explaining the development and growth oftoday’smoderncities.

WhyYouShouldCareNext time you’re flying across the country,watch the ground belowyouasyoupassover farmland,mountains,deserts,cities,andsuburbs.You’llnoticeasyougetclosertocitiesthatpopulationdensity—peopleand buildings—very slowly begins to increase, as if they are in orbitaround the central city. The farther away from the center you go, themore space there is between these “objects,” until the land becomeswidespacesoffarmlandorotherwiseuninhabitedspaceswithoccasionalspecklesoffarmhouses.Betweenthesemoremassiveobjectsarefleetsoftrucks, planes, and sometimes boats that travel back and forth withshipmentsdestinedforonecityorthenext.Thesevehiclesmostlytravelbetween the larger towns and cities, bypassing the smaller entitiesalmostentirely.Thisishowtheworldofpeopleismade.Tradegravityiswhatallowsindustrialization and urbanization to occur and makes growth anddevelopmentpossible.Tradegravityisthemostbasicpremiseofcapitalmovementoutofwhichourmodernworldofglobaleconomicsformed.

73.INDUSTRIALIZATION

When people cluster together, producing and trading, the focus of aregion’s production capabilities shifts away from agriculture. Primarygoodssuchasagriculture,naturalresources,andtheproductionofothernaturallyoccurringassetsarestillcriticalforproducinggoods.Ifanyofusbegan tostarve,we’dprobablystopwhatweweredoingand try togrowsomefood.Fortunately,asinglefarmercanfeedagreatnumberof

people—provided he has the tools he needs. It’s from this need thatindustrialization begins: theworkforce comes to include peoplewhoseprimary production function is inmaking secondary goods, which aremanufacturedratherthanproducedfromnaturalsources.Such manufactured goods improve the quality of life for people,

providing comfort, health, and education, further increasing theirproduction potential and giving them greater wealth accumulationthroughadditionaltrade.Theprimarysourcematerialsofindustrializationarenaturalresources

andhumanresources.Naturalresourcesreferparticularlytohigh-utilitygoodsthatmakeitpossibleforthosewhoprocessthemtotradeahighpercentageof their totalproduction.For instance,cornyields farmoreediblefoodperunitofeffortbyFarmerJonesthanheconsumes.FarmerJones sows the corn, waters it, and, eventually, harvests it. He easilyfulfillshis ownneeds (and thatofhis family) for cornandproduces asizeable surplus. In contrast,palm treesyield little food relative to theamount of work it takes to extract it. In consequence, the surplusgeneratedafterallthateffortisquitesmall,ifitexistsatall.Thisisthereasonweeatmuchmorecornthanpalmheartsandcoconuts.

WhatYouShouldKnowThereare threebroadcategories intowhichalleconomicproduction

falls:primary,secondary,andtertiary.Forproductionofonecategorytobecomeprevalent,publicneedforthepriormustfirstbemet—primarygoods must be adequately produced before production of secondarygoodscanbecomeanyone’sprimarysourceofproduction,andsoon.

Primarygoodsareproducedfromnaturalsources—food,metals,stone,animals,etc.Thesearethethingsthatallowustoeat,buildshelter,makeclothes,andmeetourmostbasicsurvivalneeds.Untiltheseneedsarefullymet,peoplewillpursueprimaryproduction.However,let’ssupposethatinasmallvillagetwoorthreefarmerscanreadilyproduceenoughfoodforeveryone…providedtheydon’thavetomaketheirowntools.Thatworksoutfine,becausenowotherpeopleinthevillagecanfocusonproducingfarmtoolsthefarmersneed.Inexchange,thefarmersgivethetoolmakersa

portionofthefoodthey’vegrown.

Together farmers and toolmakers produce more than they couldseparately,andnowonegroup(thetoolmakers)isproducingexclusivelysecondary goods. Assuming their secondary needs are beingmet, theycanmoveontotertiarygoods.Tertiary goods aren’t really goods at all—they’re services. These areoftenconsideredtheleastnecessaryforsurvivalbutthemostimportantfordevelopment.Servicesincludeteaching,research,defense,andotherinteractionsnecessarytoimproveeconomicdevelopment.Nowthatweunderstandtherequirementsoftradegrowth,weneedtoattract the people who will be involved in the trade. As explainedpreviously,that’stheroleoftradegravity.Oncepeopleandtrademeetinasinglepoint(amarketplace,bazaar,tradecenter,oranyotherformofcentralizedmeetingplace),thistradeiswhatallowsindustrializationtooccur.

WhyYouShouldCareIndustrializationistheprocessbywhichamodernnationforms.Ourcities grow from smaller centers of trade, developing industrial areasthat specialize in manufacturing goods, which are then sold incommercialareas(retailandotherformsofdistribution,bytheway,aretertiarygoods).It’sallwithineasyreachofthoseresidentswhomigratedfromotherplacestoworkproducingmanufacturedgoodsandtradeforothergoods.Theserelativelysmallpoints,geographicallyspeaking,aredividedbyapatchworkoffarmlandthatisstillthefundamentalsourceforsustenance.Thatiswheretheglobalaspectcomesintoplay.Industrialization requires the movement of resources. Trade gravitydrawspeopletoepicentersoftrade;businessesproducehere;peoplelivehere;allthetradebetweencompaniesandindividualshappensinthesecities.Industrialization isn’t about human resources, though, even ifattracting workers is a natural outcome of industrialization. Instead,industrialization is the process by which physical capital assets aredrawntoindustrializedareas.Rawmaterialsarebroughtprimarilyintothesemanufacturing-based,denselypopulated regions, thendistributed

assecondarygoodsinproportionsthattendtofollowthedensityofthepopulation. This redistribution of resources across vast regions intoconcentrated points for production allows for increased growth(increasedproduction)anddevelopment(increasedqualityoflife).As we develop new methods of production, the amount of surplus

goodsproducedincreases,allowingforincreasingspecializationoflabor,increasing trade surpluses that produce wealth, and increased totalresourcesavailableamonganequalpopulation.Thisincreasestheassetsthat can be allocated to improving life rather than merely surviving(althoughitdoesn’talwaysworkthatway).

74.URBANIZATION

Whereasindustrializationfocusesprimarilyonthemovementofphysicalassets such asmachines, rawmaterials, and the like into concentratedindustrial areas, urbanization is the process by which people areattracted to these same regions and become concentrated in them. Astrade increases the number of jobs available, the companies seekingworkerswillcontinuetoofferbetterwagesandbenefitsuntilthepeopleofthesurroundingareasmovetothecentralizedlocationoftrade(a.k.a.the city). People from smaller townswill tend tomove to larger ones,attractedbybetterwagesandworkingconditions.Cities date back to the third or fourth millennium B.C. People, by

nature,aresocialcreatures,andwearedrawntootherpeopleinorderto gain mutual benefit from each other. In large enough numbers wechangethelandscapewithourdwellings.Urbanizationcomesintwoforms:highdensityandlowdensity.High

density urbanization is often associated with cities where people livecloser together in apartments, condominiums, or lofts. However, theproblems associated with such congestion lead people to seek lower-densityurbanizationintheformofsuburbs.

WhatYouShouldKnowOnan international scale, national bordersmean little regarding the

migration of people or goods. Just as capital will cross borders asinvestors and businesses search for newmarkets inwhich to sell theirgoodsorpurchasesupplies,peoplewillcrossnationalboundariestoseekoutopportunitiesforwork.Thecentralizationoftradeexchangesandindustrializationthatoccurs

inurbanareasallowsfornotonlyworkingopportunities,butalsocausesincreasedprices,whichtendtoincreasethecostofliving.Forexample,NewYorkCityhasexperiencedmuchhigherregionalizedinflationthanOmaha,Nebraska.Omahahasmuch lowerwagesbutalsomuch lowerprices.Theresultissomethingofacontradiction:Peopleareattractedtothecitybecauseofbetterworkingopportunities,whileothersleavethecity in search of a lower cost of living. There is, inarguably, a greaterdiversity of work in urban areas than in rural ones, as increasedspecializationand industrializationrequireahighervarietyof full-timeroles.Nomatterwherepeopleare in theworld, though, thesemotivations

remain the same. Governments try to limit this movement, creating ablackmarketforlabor.

WhyYouShouldCarePeoplemovetoacityforjobs;peoplemoveawayfromacityinorder

tocutcostsandfindanallegedlyhigherqualityoflife.Investorsbuyupas much property as they can in areas beginning the urbanizationprocess because of the increased value of property. When all this isappliedtoaninternationallevel,someuniquedynamicsarecreated.Nationalbordersaren’talwayseffective incontrolling themovement

ofpeopleoncetheeconomicinfluenceshavealreadybeenset inplace.Thedevelopmentofcities,changingcomparativeeconomicgrowth,andcostandwagedifferentialsdofarmorethangovernmentpoliciestoalterthedirectionofmigration.Within cities, similar linguistic and culturalgroups tend to cluster. For instance, one portion of a city may haveheavy Korean influence and another might have heavy Germaninfluence. This increased exposure to other peoples promotes a widervariety of differences among people, giving urban areas more liberalpoliticalideascomparedtotheirruralcounterparts.

75.URBANSPRAWLANDDECAY

Thehighconcentrationofpeopleandcapitalisn’tnecessarilyadesirableoutcome. It brings with it a number of problems: pollution, noise,congestion, regionalized inflation, andmuchmore. In fact, those whocanafforditoftenmoveawayfromurbanareas.Themostdirectresultisthe formation of suburbs, mostly residential areas of people who canafford tomove away from the congestion of the city but remain closeenoughtoworkthere.Asthemetropolitanareacontinuestoexpand,theability of the city to attract people and resources diminishes. In otherwords,thetradegravityoftheurbanandindustrializedregionslessens,andasthecitycontinuestoexpandoutward,itsassetswillshed,blownawayliketheouterlayersofadyingstar.The geographic expansion of a metropolitan area into what waspreviouslyfarmlandiscalledurbansprawl.Whiletherearenoobjectivemeasurestodeterminewhenanurbanareareachesthe“sprawl”stage,thereareconsistenttraitsamongsprawlingcitiesthatcanbeusedasachecklist:

Single-purposezoning

Low-densityoccupationthatincludeswidespacesbetweenbuildingsandasignificantproportionofsingle-floorbuildings

Dependencyonvehicleownershipresultingfromawidegeographicdistributionofdailyneeds

Theprocessbywhichtheurbanareasthatonceattractedpeopleandcapitalnowrepelthoseproductioninputs,causingthecitytolosevalueand production potential, is called urban decay. Without people tomaintainthecity,resources,ortheincomethatcanbetaxedtosupportand facilitate citymaintenance, entire regions of the citywill fall intodisrepairordecay.

WhatYouShouldKnowUrban sprawl and urban decay perpetuate each other. As a cityexpands,thepartsthatoriginallyattractedpeopleandassetsstarttofall

apartandbecomeghettos.Asthepovertyanddisrepairassociatedwithghettos turn to crime and blight, people and companies move furtherawayfromthecities.Thisisanaturalpartoftheprocessofregionalizedeconomic growth, the end of a city’s life, but it is one that ismanageable.Urban sprawl and decay represent the part of the life cycle ofeconomic growth; resources move away from their cities of origin inpursuit of more lucrative opportunities where growth can occur onceagainregardlessofinternationalborders.Asaresult,thosecitiesthatarehardesthitbytheseproblemsarethosewithacomparativedisadvantagein the industries currently operating within their limits. Consider thedifference between Detroit, Michigan, and Los Angeles, California.Detroit’sprimaryindustrywasautomobilemanufacturing,anindustryofprimarily low-ormoderate-skilled labor that could be performedmorecheaply outside the United States. Detroit, which was alreadyexperiencinganextremedegreeofurbansprawl,lostthemajorityofitseconomic resources.By contrast, theprimary industries of LosAngelesare those in which the United States has a comparative advantage.Ratherthanbeingsubjecttothefullextentofurbandecay,LosAngelesactually continues to attract workers, in part through internationalmigrationfromalow-toahigh-incomeregion(discussedintopic76).

WhyYouShouldCareThemovementofcapitalisazero-sumsituation.Whenonearealosespeople and capital, another area gains those resources. Many peopledon’twanttomovetoanewtown,andsomewillrefusetolearnanewcareer. While the latter situation can’t be avoided, the former ismanageable, but it requires an understanding of global economics andthemechanicsbywhichcapitalmoves.Oftenduringdevelopmentprojectsasingleareawillseeagovernmentinjectionofresourcesthatdoesnothingmorethanrearrangethelocationof wealth; new trendy “hot spots” displace impoverished populationswho must now move as property values increase. New constructionremoves cheap housing, and new ghettos form elsewhere in the samecity.Thisarrangingandrearrangingofassetswithinasinglecityhelpsto sustain a minimal degree of urban maintenance but does little to

resolvetheproblem.

76.INTERNATIONALMIGRATION

Internationalmigrationisaveryemotionallychargedpoliticalsubjectinmanynations.Beforewejumpintoitscausesandeffects,let’sgetsometerminologyoutoftheway.Emigration occurs when a person leaves his own nation; immigration

occurs when a person enters another nation. In other words, it’s thesame thing but from different perspectives. Amigrant is someonewholeavesherhomenation to live in anothernation either temporarilyorpermanently. An expatriate is someonewho leaves his home nation tolive in another nation either temporarily or permanently. The onlydifferencebetweenthetwoisconnotation.Thetermexpatriatetypicallydescribes someone froman economicallydevelopednationwhomovesto a less developed nation.Migrant usually describes someone from aless developed nation seeking a better life in a nation with moreeconomicdevelopment.Legalmigrantsarethosewhotravelbetweennationswiththeconsent

of both countries. Illegal migrants cross borders without permission.Somenations restrict people from entering their nation; others restrictpeopleleaving.Refugeestatusissometimesextendedtothelatter,oftenbasedonpoliticalconsiderations.

WhatYouShouldKnowPeoplemovebetweennationsinordertoreceivesomethingtheycould

not get in their home nation. Perhaps it’s new jobs, new customers,cheap labor, natural resources, a partnership—any number of thingsthey can’t find at home. The things that motivate people can varysignificantlybuttherearetrends.Migrants’motivationscanbediscernedbylookingattheirhomeandhostnation.The majority of migrants move from nations with lower income to

countries with higher total income.With better working opportunitiescomesabetterqualityoflife.Whenartificialbarriersareputinplaceto

restrictthatmigration,justaswhentraderestrictionsareimplemented,ablackmarketforms; inthiscase, illegalmigrant labor. Inmanycasespeoplemovefromonecountrytoanotherseekingabetter,morestablequalityof life thatavoidspoliticalorsocialvolatilityorother formsofinjustice.ThiswasthecasewithmigrationfromGermanypriortoWorldWarII.

WhyYouShouldCareTheexactmotivationsformigrationvary,buttheyallresult froman

incompatibilitybetweenwhatisbeingsoughtandwhatisavailable.Itistheexistenceofthisdisjunctionthatallowstheproblemofmigrationtopersistaswellasfuelingtheblackmarketforlabor.Let’s talk for amoment about the border between theUnited States

andMexico.PeopleinMexicooftenwanttomovetotheUnitedStatesbecauseof

thehigher incomeavailable; usuallymigrantworkers intend to send aportionof that incomeback toMexico.Opponentsof illegal (andevenlegal)migrationarguethattheseworkersarecompetingwithAmericanworkersforalimitednumberofjobs.However,inordertocompetewithmigrantworkersforthosejobs,Americanworkerswouldhavetoacceptapaycut.Obviouslytheydon’twanttodothis.Itisthatcompetitionforjobs, though, that increasedmarket competitiveness forgoodsmade intheUnitedStates,makingitaneconomic“superpower.”Compare this to China’s economic growth since the 1970s. China’s

expansion is fueled primarily by people migrating from farm regionswhoarewilling toaccept jobs forvery lowwages. It’s thishuge laborforce that gives China its production potential.What ifwe split Chinainto two nations, dividing the cities from the farmland? Chinesecompanies would now have to draw a huge percentage of their laborforcefromtheranksofmigrantworkers.Theywouldbecompetingwithlocalsoveralimitednumberofjobs.The bottom line here is that whenwe open up a border and allow

workers to freely cross it in search of jobs, the average income eitherincreasesordecreasesinordertoreachanewequilibrium.Wecanconductaninterestingthoughtexperimentbyaskingwhether

the removal of minimum wage laws would reduce migration. Ifcompaniesweren’tforcedtopayaminimumwagetopeople,wouldtheystillhireillegalimmigrants,orwouldtherebeenoughlaborerswillingtoworkcheaplythatemployerswouldnotriskfederalpenaltiesforhiringan illegal migrant? The answer is that migration would decreasesignificantly, but that poses another question: Is that a scenario thatpeoplewillaccept?Theanswer—atleastintheUnitedStates—is,“no.”

77.WESTERNIZATION

“Westernization” is themostprominentexample in thenineteenthandtwentiethcenturiesofculturalappropriation.BeforeWesternizationthepopular term was Europeanization, and after Westernization we weregivenAmericanization.Anytimeanationexportsitsgoods,orpeoplefromthatnationmigrate

to other places on the planet, its culture is distributed along with itsgoodsandpeople.Asotherpeopleareexposedtothebitsandpiecesofaforeignculture,theyoftenadoptthosebits.Sometimesit’sthenoveltyofsomethingconsideredexotic.Forexample,inmanyWesternnationsit’sconsidered trendy to wear Chinese characters on your clothes or astattoos. In China, though, it’s considered trendy to wear clothes withEnglishwordsonthem.Theexposureonepeoplehas to thecultureofanotherpeopleoccurs

almost exclusively through themovementof capital andpeopledrivenby that capital.Aspeople travel fromcountry tocountry, they tendatfirsttocluster,seekingoutotherswithacommonlinguisticandculturalheritage.(Think,perhaps,ofChinatowninCaliforniaandNewYork,orperhapsofChaoyangDistrictinBeijing,whichboastsahugepercentageofforeigners.)Graduallythisbreaksdown,andthepopulationbecomesmoreintegrated.

WhatYouShouldKnowThe spreading and adoption of culture happens for two primary

reasons:functionandaesthetics.Eitherway,underlyingeconomicforcesdrivethespreadofculture.

1. Function.Themethodsandideasthatdrivetheprocessesoforganizationsspreadquicklyiftheyaresuccessful.Forexample,theprofit-drivenproductivityoftheassemblyline,aspopularizedbyHenryFordinDetroit’sautomotiveindustry,wasaculturaliconoftheearlytwentiethcentury.Thesuccessofthismethodquicklyspreadtoothernations;JapanadoptedtheideainitsownautomotiveindustrymoresuccessfullythaninAmericaandovertooktheUnitedStatesinautomotiveproductionefficiency.Inthelatetwentiethcentury,theAmericanautomotiveindustrylookedtoJapanforwaystoimproveitsownmethodsandbecomecompetitive.Thespreadofideasacrossculturalboundariesallowsfortheevolutionofanideabyframingitintoanewculture.Likeavirusthattravelstheglobe,ideascanbecomesomethingalmostentirelynewbythetimetheyreturntotheirstartingposition.

2. Aesthetics.Oncepeopleareexposedtoanovelidea,itcangrowinpopularitybeyondsmallnichemarkets.ReturningtoJapan,formanydecadesintheUnitedStatestheiranimationwasalmostunheardof.AsrelationsbetweenthetwonationsgrewandmorepeoplewereexposedtoJapanesecartoons,animegrewinpopularity.Now,notonlydoestheUnitedStatesimportahugeamountofanimationfromJapan,butAmericanproducersofanimationaredevelopingproductsinanimestyle.

Culturespreadsbecausethereisdemandforthegoodsandservicesofothernations.Thisincreasescompetitionandcreatesnewpreferencesinaesthetics,allowingcompaniestoprofitfromthesenewmarkets.

WhyYouShouldCareThe spread of culture, especiallyWestern culture, is a phenomenon

that concernsmany commentators. There has been an outcry that theincreased popularity of McDonald’s is destroying traditional food andagricultural industry, contributing to unhealthy eating habits, pushingtraditional farmers out of work, and replacing the original foodproduction methods of many regions. Not all change is good, theargumentgoes.There’sadeeperproblem.Asculturesinteractandmerge,westartto

see a cultural homogeneity across national boundaries.Many fear thisendangersstandardsinart,music, literature,andotherfieldsculturallyunique to different nations. The concern is that by expanding culturalexposure,wearedestroyingculturalvariety.Whilethisisavalidworry,sofartheworldappearslargeenoughto

continuebreedingnewideas,beliefs,andpreferencesthatwillgeneratetheirowndynamicculturalvariationsovertime.

78.CAPITALFLIGHT

When capital moves away from nations it’s called capital flight.Specifically,capitalflightreferstoarapidflowofcapitaloutofanation,although it can alsomean a slower but systematic outflow of capital.Capitalflightisusuallyassociatedwithoneoftwothings:adifferentialin domestic economic policies that presents a clear opportunity forinvestorsandcompaniestogeneratemoreincomeorincurfewercostsinadifferentnation,ornaturallyoccurringeconomicdifferentialsthatalsopresentsuchanopportunity.Thecapitalinquestioncanbeinvestments,money,entrepreneurship,physicalassets,inventories,machines,andjustaboutanythingelsethatisn’tdirectlyattachedtothecountryitself.Forinstance, diamonds can move across international borders, but adiamondminecan’t.Aswithmost things in internationaleconomics,capital flightdoesn’t

necessarilyrefer to justcapital leavinganation. Itcanalsohavetodowith the flight of capital from a state, province, city, or even anindividualdistrictwithinasinglecity.

WhatYouShouldKnowWhen an opportunity for greater profits presents itself in another

nation(orgeographicarea),companiesandindividualswillfollowthatopportunity.Thebusinessmaywanttodecreasecostsor investorsmaywantto increasetheirreturnson investmentor improve income.Manythingscanchangetheeconomicdynamicbetweentwonations,makingonenationmore attractive than the other. But all this comes down toonemotivation:increasingwealth.Itis,afterall,theintentionofnearly

allbusinessesandinvestorstomakemoney.

WhyYouShouldCareThe consequences of capital flight can be devastating.As companiesmove their assets away from a nation, they take with them jobs andproduction that contribute to the nation’s economic growth and tradepotential. They take with them wealth that is associated with asuccessfulbusinessandthepotentialforexistingbusinessestogrow,fornew businesses to form, and for innovation or research to be funded.Capitalflightthusposesaseriousriskofharmingtheoveralleconomichealthofanation.

79.BRAINDRAIN

Whereascapitalflightoccurswheninvestmentsandphysicalassetsmoveawayfromanation,braindrainmeansthedepartureofhighlyeducatedor skilled people. These people have specialized knowledge, skills, orexperience that cannot be easily replicated, making them highlyvaluable.Theirdepartureoftenresults ina lackofpeople to trainnewskilledworkers,alackofnewdevelopmentandinnovation,andalackofnationwidetechnicalprowess.The ability of a nation to develop and produce new or advancedtechnologies, processes, or other outputs that require a highlyspecialized skill set is critical to that country’s ability to maintaininternational competitiveness and the kind of market responsivenessrequired for economic growth. Such jobs often include scientists (bothphysical and social), professors, engineers, mathematicians, andphysicians and others in the medical field. The flight of these skilledpeople occurs when they emigrate or when students and workers goabroadforschoolorjobsandneglecttoreturn.IntheearlytwentiethcenturyChinasufferedasignificantbraindrain.Many students were sent abroad to study and bring home newknowledgeandskills;manydidnotreturn.OtherslefttoescapethecivilwarbetweentheKuomintangandtheChineseCommunistParty.Inthe1960s, as a result of the anti-intellectual movement known as the

Cultural Revolution, many educated Chinese fled abroad. Even today,decadesafterextremesocial,political,andeconomicreforms,thisbraindrain continues, albeit in modified form. The Chinese still rely veryheavily on unskilled or low-skilled labor, and outsource their need fortechnicalorotherwisehighlyskilledworkers.

WhatYouShouldKnowPeople change nations either to escape domestic limitations or topursue foreign opportunities. In many cases throughout history, thosewith specialized skill sets had the opportunity to escape their homenationprecedingatimeofconflict.ManypeopletriedtoleaveGermanyandthesurroundingareasprior toandduringWorldWar II,but thosewhohadspecializedknowledgeorusefulskills,suchasAlbertEinstein,foundmanymore nationswilling towelcome them than did unskilledrefugees.Similar instanceshaveoccurred throughout the formerSovietUnion,easternEurope,theMiddleEast,andpartsoftheUnitedStates.Theother reason forbraindrain is thepursuitofopportunity.Whenpeople leaveanation inpursuitofbetteropportunities they’re lookingfor what psychologist Frederick Herzberg calls “motivators.” Thesemotivatorsinclude:

Theopportunitytopursuefulfillmentthroughadditionalresearchopportunities

Theopportunitytopursuenewknowledge

Theopportunityforrecognitionandstatusandotherthingsthatdrivepeopletoexcel

Bycontrast,whathecalls“hygienefactors”arethosethatrelatetothelevelofwages,jobsecurity,andsafeworkingconditions.They’renotaspowerfulan incentive forpassion-drivenworkers,whoare theprimarysourceofbraindrain.Thenationsthatbestfacilitateandsupportthesepursuits tend to attract specialists away from nations that restrict thesamepursuits.

WhyYouShouldCareBrain drain results in lower levels of development, innovation, and

decreasedcompetitiveness intheinternationalmarkets. Inthelongrunitwillleadtoaslowingorcompletestagnationofthenationaleconomy.Thelackofexperiencedorskilledperspectiveswillreducetheabilityofsectorstoanticipateorrespondtomarketdynamics,andtendsto limitimprovementsinsocialorpoliticalinfluences.

80.TAXMANAGEMENT

One variable of which investors and business executives are acutelyaware when deciding in what country to allocate their assets is anation’s taxpolicies.There arehundredsof different taxes that canbelevied on money earned within a nation, money earned outside thehomenation,moneymovedbetweennations,assetsownedinanation,andon anywork that is done that adds value to a product. The taxesleviedbygovernmentsonpeople,businesses,orassetsallinfluencethemovementofcapitalacrossinternationalborders.For instance: PaperCup, Inc. manufactures paper cups in bothFreedonia and Brungaria and exports those paper cups to nations allaroundtheworld.Freedoniaraisesitsincometaxto50percent,cuttingtheincomethatPaperCup,Inc.,makesaftertaxes.SothecompanydropsproductioninFreedoniaandshifts themajorityof itsproductionassetstoBrungaria.ThechangeinthetaxratesbetweentwonationsgavePaperCup,Inc.an incentive to changewhich nation it did business in. This incentivecomes from a calculable decrease in tax burden that will result inchangingthenationinwhichtheseassetsareheld.This isn’t taxmanagement, exactly, though. Taxmanagement is theprocess by which company management decides how to reduce theorganization’s tax burden. Through the process of tax management,assets move in response to changes in tax policy. If it becomesgeneralizedamonganumberoffirms,thiscanbeafactor,ofcourse,increatingcapitalflight.

WhatYouShouldKnow

Taxes influence not only the distribution of international assets andproduction, but also the trade that occurs around the world. Everynation taxes imports from other nations differently. So relativedifferences in tax rates not only influence where assets are held butbetweenwhich nations exchangeswill take place and inwhich nationthosetransactionswilltakeplace.Sometimestheavailabilityofsuppliersorcustomersissosignificantinanationthatit’sworthitforthecompanytooperatethereinspiteofthehigher tax rate. A nationmight provide services to employees such asfree health care, which would bemore expensive for the company toprovide than the cost of the higher taxes. As with everything, it’s aquestionofcost-benefitanalysis.Sometimes it’s possible to get the best of allworlds. For instance, ifyournationhasa10percentimporttariffonicecubesfromAntarctica,itmightbepossibletofindathird-partyintermediarylocatedinanationthat has no tariff. Ice cubes from Antarctica are exported to animport/exportcompany inBrungaria,whichhasno tariffon icecubes.Your company then imports from Brungaria, circumventing the tariffentirelyandwithout incurringthecostsofrelocatingelsewhere for thepurposeofimportingicecubesfromAntarctica.

WhyYouShouldCareTax management decisions are not exclusive to large multinationalorganizations that hold assets in multiple nations. If you’re a typicalsmallinvestor,youhaveaccesstointernationalmarketswithvaryingtaxpolicies that can influenceyour returnson investment.Even thegoodsthatyoubuycome fromdifferentnationsand so canbe influencedbytaxpolicy.Ifyouworkinmultiplenations,thetaxesyoupaycomparedto the services you receive can play a role in your decision to eitheracceptajoborgotoschoolinthatnation.Whetheranyofthisisagoodor a bad thing really depends on what you’re trying to do. All otherthingsbeingequal,though,peoplewillseekoutalocationfortheirtradeandresourceswiththelowestpossibletaxburden.

81.TRANSFERPRICING

Transfer pricing is the process by which an organization attributes aprice to its assets that are being transferred between its differentdivisions. It provides data that helps a company decide whether tooutsource services as well as to determine the profitability of variousdivisions.Transferpricingisusuallyappliedtoinventoriesorworksinprogress.

Theunfinishedproductisgivenafairmarketprice,givenitsproductioncosts up until that point as well as the price for similar unfinishedproducts in the market. Then the company’s different divisions“purchase” that unfinished product from other divisions. Although nocashactually changeshands, thisprovidesanoutline for thecostsandaddedvaluesthatcanbeattributedtoeachdivisionwithinacompanyasasingleitemistransferredbetweentheseparatedivisions.Whilethisprocess,byitself,providesimportantinformationaboutthe

financialandoperatingefficienciesoftheorganization,whenappliedtoglobal economics there are some important implications tied to thisprocess for purposes of taxes, outsourcing, and the relocation ofoperationswithin a single organization. The information derived fromtransfer pricing contributes to important decisions, including tradeproduction,employment,taxrevenues,investments,andmuchmore.

WhatYouShouldKnowThe price that organizations place on their assets being transferred

betweenforeigndivisionsdeterminestherateatwhichthoseassetsaretaxed.Oftenfulltariffsaresuspendedinthosecaseswheretheassetsaretransferredbacktotheoriginal locationafterbeingworkedon.Insteadanorganizationmayjustbechargedavalue-addedtax(VAT),whichisataxon theportionof the increasedvalueof theassets asmeasuredbythedifferencebetweentheoriginaltransferpriceandthetransferpricegoingback.Let’slookataquickexample:

Step1:AlpacawoolfromabranchatCompanyAinChileistransferredtoEcuadorforUSD10perunit,becausethat’swhatthecompanycouldsellitforonthemarket.

Step2:ThealpacawoolisspunintoyarnintheEcuadorianbranchofCompanyA.

Step3:TheyarnistransferredbacktotheChileanbranchatUSD11perunit.

Step4:TheaddedvalueisUSD1perunit,sothat’swhatCompanyAwillbetaxedon.

Notethatinreallife,thetaxratedependsonthetaxpoliciesbetweennations. Our example explains how added value works; it also showsthat profits are not amotive in transfer pricing. The reason for this isthat only the end product generates profit.When the company’s usingtransferpricingtodeterminewhetherornottooutsourcegoods,itwantsthemostcompetitivepricingavailable.That brings us to the second primary use for transfer pricing: the

decision to outsource. When a company knows the transfer price foreach of the steps of production, it can more accurately determinewhether to outsource any process. If an external organization canprovide the value added to a piece of inventory at any step in theproduction process more cheaply than the company can provideinternally,thenthecompanywillprobablyoutsourcethatoperation.

WhyYouShouldCareIf you’ve ever wondered how an organization decides whether to

move its assets, operations, branches, or jobs across internationalboundaries,nowyouunderstandaveryimportantstepinthatdecisionmaking. It shouldbeobvioushowthedecisiontomoveoperationscaninfluencethatcompany’semployees,thecoststhatacompanyincursaswell as the prices it charges as a result, and even the trade in bothnations.

82.INTERNATIONALLOGISTICS

The details underlying international transactions contribute greatly tothefeasibilityofcapitalmovement,thecostsassociatedwithtrade,andtherisksassociatedwithglobaleconomics.Understandingtheprocessbywhich these transactions actually take place and by which thingsactually move is key to global economics; we’re out of the realm of

theoryhereandhavebothfeetfirmlyontheground.This particular issue is broken down into a series of steps, and

problems are frequently encountered when fulfilling those steps. It’smuch simpler thanmany suspect, and outlining the steps should helptakesomeofthemysteryoutoftheprocessoftradingandtransferringgoodsworldwide.

WhatYouShouldKnow

Step1:Thebuyerandsellerdrawupacontractforthepurchase/saleofgoods.Nothingtoocomplicatedhere.

Step2:Thebuyer’sbankgivestheselleraletterofcreditthatensuresthepaymentoftheagreed-uponprice.BasicallythisworksjustlikeanIOU:Thebankpromisesthatthebuyerhasmoneyavailableandthatmoneywillbetransferredtotheselleruponproofthattheshipmenthasbeenmade.

Step3:Thesellerconsignsgoodstotheshipperandisgivenabilloflading.Theshipperisnothingmore,usually,thanthenationalpostalserviceorsomeshippingcompanysuchasFedExorUPS.Thebillofladingincludesinformationaboutthecontentsoftheshipment,value,destination,andeverythingelse.Thesellerkeepshisportion,aportiongoesontheshipment,andthepostofficegetsacopyaswell.

Step4:Thesellergivesthebillofladingtohisbank.Theseller’sbankthencontactsthebuyer’sbankforthecashtransfer.

Step5:Theshipperdeliversthegoodstothebuyer.

Whyall thesesteps?Theirobject is tocreatepaperworkto tracktheshipmentsandmakesureeveryonestayshonest. In lieuofusingbanksas the third parties, some companies act exclusively as middlemen inthese transactions. For apercentageof the transactionvalue, theywillholdontotheshipmentuntilpaymentisreceivedandthentransferthemoneytothesellerandthegoodstothebuyer.Almostallshippershavedifferentoptions,butthereisusuallyatrade-

off between speed and security, and cost.Air shipping tends tobe the

most expensive but also the fastest andmost secure. Shipping by boattendstobethecheapestbutalsotheslowestandriskiest.

WhyYouShouldCareSince trade and transfers are within the reach of everyone, a

familiaritywiththeprocessnotonlymakesitmucheasiertoparticipate,buthelpsopendoorssoyoucanbenefitmorefromtheabilitytotradeandtransfer.Forsmallbusinesses,whichcanmostgreatlybenefitfromtrade but frequently aren’t aware that these options are available, anunderstandingofinternationallogisticscangreatlyexpandtheirmarketbaseaswellasmakeavailablecheapersourcesofsupplies.

83.INCOTERMS

International commercial terms, or incoterms, are the terms used in acontracttodeterminewhoisresponsibleforexecutingcertainaspectsofshipping,who is responsible forpaying for certainaspectsof shipping,and at what point responsibility and accountability of a shipmentchanges hands. Particularly when they include third-party shipping,storage,ordistribution,understanding theirusagecannotonlygreatlyreducetheamountofconfusionshouldsomethinggowrong,butitcanalsoreducetheamountofriskassociatedwiththeshippingprocess.

WhatYouShouldKnowHere are some of the most common incoterms. Should ownership

change hands in the process of using an intermediary in the shippingprocess, there will be several legs of the journey, all with variousincoterms but not necessarily separate contracts (one contract canincludeseverallegsofshipping).

EXW(Exworks):Thebuyerisresponsibleforallaspectsoftheshipmentonceitleavesitspointoforigin.

FCA(Freecarrier):Thesellerhandsoverthegoods,clearedforexport,fordisposalbythefirstcarrier(namedbythebuyer)atthenamedplace.Thesellerpaysforcarriagetothenamedpointof

delivery,andriskpasseswhenthegoodsarehandedovertothefirstcarrier.

FAS(Freealongsideship):Thesellermustplacethegoodsalongsidetheshipatthenamedport.Thesellermustclearthegoodsforexport.

FOB(Freeonboard):Thesellermustloadthegoodsonboardthevesselnominatedbythebuyer.Costandriskaredividedwhenthegoodsareactuallyonboardthevessel.Thesellermustclearthegoodsforexport.Thebuyermustinstructtheselleraboutthedetailsofthevesselandtheportwherethegoodsaretobeloaded,andthereisnoreferenceto,orprovisionfor,theuseofacarrierorforwarder.

CFR(Costandfreight):Thesellermustpaythecostsandfreighttobringthegoodstotheportofdestination.However,riskistransferredtothebuyeroncethegoodsareloadedonthevessel.

CIF(Cost,insurance,andfreight):Thesellermustpaythecostsandfreighttobringthegoodstotheportofdestination.However,riskistransferredtothebuyeroncethegoodsareloadedonthevesselbutthesellerpaysfortheinsurance.

DAT(Deliveredatterminal):Thesellerpaysforcarriagetotheterminal,exceptforcostsrelatedtoimportclearance,andassumesallrisksuptothepointthatthegoodsareunloadedattheterminal.

DAP(Deliveredatplace):Thesellerisresponsibleforthecostsoftheshipmentexceptcustomsandtariffs;ownershipchangeshandstothebuyeroncethepackagereachesthefirstcarrier,asdoestheriskoftheshipment.

CPT(Carriagepaidto):Thesellerisresponsibleforallaspectsoftheshipmentexceptcustoms,tariffs,andinsurance.

CIP(Carriageandinsurancepaidto):Thesellerisresponsibleforallaspectsoftheshipmentexceptcustomsclearanceandtariffs.ThisisthesameasCPTexceptthatriskcontinuestostayinthehandsofthesellerratherthanchanginghandsatthefirstcarrier.

DDP(Delivereddutypaid):Thesellerisresponsibleforallaspects

oftheshipmentuntilitisreceivedbythebuyer.

WhyYouShouldCareUnderstanding,oratleastbeingfamiliarwith,thetermsofashipping

contractcanbeagreatbenefitforanylargeorvaluableshipment.Ifyoudon’tunderstandanythingaboutit,theprocessofshippingcanholdjustas much risk of loss as transaction risk—perhaps more. It is notuncommonforagreements tobemadebetweencompaniesandvariousintermediaries, forming agreements to increase revenues by referringshipmentspaid forbytheotherparty tospecificcarriers.Ontheotherhand,understandingtherisksofshippingandincludingtermstoreducethoseriskscanbecritical.Eveninrecentyears,forexample,theworldhasseenanincreaseintheactivitiesofpiratesoffthecoastsofAfrica.Ifyour shipment is stolen,who is responsible for the loss?Whopays forthe insurance? Such information should be included in the contract.Unlessyouknowthatsuchoptionsareavailabletoyouandwhattolookfor,youmaywindupassumingtherisk.

CHAPTER9Integration

As our understanding of economics has improved over the years,governments have become aware that facilitating free trade betweennations is greatlybeneficial.True, theyoften fallback into the trapoftraderestrictionsandprotectionistpolicies,butonthewholetheworldismovingtowardgreatereconomicintegration.InChapter5wediscussedtheburdensoftraderestrictions.Herewe’ll

go in the opposite direction, toward fewer restrictions and greaterintegration. As multiple nations become highly integrated they formtradeblocs.Theseamorphousentitiessometimesspanentirecontinentsormultiple continents and unite different governments under a singleeconomy.The role these tradeblocs play in the global economy, theirinfluenceoverandbytheirmembernations,andwhetherornotthey’rebeneficialareallissuesofconsiderabledebate.There are trade-offs associated with integration. Increasing national

integration improves economic growth and development but reduceseachgovernment’sability toactunilaterally.Ofcourse,noneof this isnew;we live inan increasingly integratedworld.But this ishavinganincreasingeffectongovernmentpolicies.

84.FREETRADEZONES

Themost limitedformsoftradeintegrationarefreetradezones.Theseare designated areas within an otherwise closed nation in which freetrade is allowed. Imports in the form of raw materials come in, aretransformed into manufactured goods, and are exported tax-free andwithout government intervention (except, of course, for things that

directly affect national defense, such as weaponry and other sensitiveequipment).Goodsforconsumptioncanenterthefreetradezonebutarenotallowedtoleave.Free trade zones can exist in cooperation between any two nations.Sometimes the term “zone” doesn’t refer to a specific geographiclocation but to a type of business. InMexico, for instance, businessescalledmaquiladoras are allowed tooperate in amanner similar to freetradezones.Theyimportrawmaterialtoproducemanufacturedexportswithlowertraderestrictionsthanotherindustries.Since these free trade zones are designed for the import of rawmaterials to be processed into manufactured goods, they naturallyattract factories and other manufacturing facilities. This has bothbenefitsanddetriments—laxregulationsontradeandoperationscanbeeffectiveatattractinginvestmentandemployment,buttheyalsoattractcompaniesandindustriesseekingtobendrules.Free trade zones are usually set up in two types of locations:underdevelopedregionsandportregions.

Whenestablishedinunderdevelopedregions,theinvestmentandproductionthatthenewandimprovedtradepoliciesattracthelpdevelopthearea.Companiescreatejobs,increasethenation’sproductionoutput,andincreasegainsfromtradeandwealthinthearea,stimulatingdevelopmentforahigherqualityoflife.Atleastthat’sthetheory.Thereasonthatfreetradezonesareestablishednearportsisalittlebitlesscomplicated:They’reveryclosetotheshippingpointsthroughwhichrawmaterialswillbeimportedandmanufacturedproductsexported.

Since ports and waterways naturally attract trade andindustrialization,thoseorganizationsthatoperatetheretendtobeheldto a higher standard for operations andworking conditions. These arelocatedinnearproximitytootheremployers;consequentlycompetitionforworkers is a bit higher sinceworkershavemoreoptions andmoreabilitytonegotiatefortotalincome.Ontheotherhand,organizationsinundevelopedareas,whichhave fewothercompanies towhichworkersmightapply,havegreaternegotiatingpowersincetheworkershavefew

other choices of employment. This often results in poorer workingconditions.TherearefreetradezonesinmanynationsoneverycontinentexceptAntarctica. Some of the more common industries attracted to theseregions are electronics, textiles, chemicals, machining, assembly,consumer plastic products, and other products that utilize a highproportionoflow-ormedium-skilledlabor.

WhatYouShouldKnowTheargumentthatfreetradezonesareharmfulisabitmisguided.Thezones themselves don’t do any damage, but the companies thatintentionally seek out locations that they believe will not haveregulatory oversight for social or environmental impact are damaging.For the sake of this chapter,we’ll discuss the economics of free tradezonesundertheassumptionthatcompaniesinthemareoperatingwithintheparametersofthelawandthatthelawisbeingenforced.Free trade zones increase the benefits from trade and improveeconomic ties between nations without much of the generalizedcodependence inherentwith other forms of economic integration. Thisnotonlyallowsanationtodirectinvestmentandtradetotheregionsitdeems strategically important for the management of economicproductionandgrowth,butalsoallowsnationstobenefitfromtrade.

WhyYouShouldCareThe opportunities present in free trade areas attract manufacturingand assembly companies that focus on foreign markets. For people,investors,andentrepreneurswithinsuchanation, theycanhelpdirectdecision making about the movement of people or capital, while forforeignerstheestablishmentofafreetradezonecanhelpdecreasecosts.Afreetradezonecanchangetheeconomicdynamicsofanation.

85.PREFERENTIALTRADEAREA

Preferential trade areas, or preferential trade agreements, are farmorecommonthan free tradezonesbut lessbroad in their removalof trade

restrictions. These are agreements between two or more nations thatreduce the amount of trade restrictions between them, but often onlymarginally.Apreferentialtradeareacoversallthenationsthatarepartof theagreement.The limitationsontraderestrictionsbetweennationsapplytotheentiretyofbothnations;however,theyonlyapplytothosenations that are a part of the agreement. Any trade restrictions that anationhadestablishedpriortosigningthepreferentialtradeagreementstillapplytoallcountriesnotapartoftheagreement.The goal of a preferential trade area is to reduce but not eliminate

trade restrictions. This tends to increase the amount of trade in bothgoodsandservices,increasevolumeofcapitalmovingacrosstheborder,and decrease the costs associated with performing these transactions.Theestablishmentofapreferentialtradeareadoesn’tcommitnationstocooperate regarding economic policies outside the parameters of theagreement.Preferentialtradeareas,likemanyformsofeconomicintegration,tend

tospringupbetweennationsthathaveaclosegeographicproximitytoeach other. This proximity makes the economic impact of traderestrictionsmore easily viewable, and it’s easier to see the benefits offreer trade. As globalization increases, however, and the amount ofinternational exposure between nations increases, agreements betweengeographicallyandpoliticallydisparatenationsareincreasing.

WhatYouShouldKnowTherearealargenumberofpreferentialtradeareas.Forinstance:

TheLatinAmericanIntegrationAssociationhasfourteenmembernationsinCentralandSouthAmerica

TheAsia-PacificTradeAgreementhassevenmembernationsalongAsia’ssouthernridge

TheSouthAsianFreeTradeAreahaseightmembernationsalongtheborderbetweenAsiaandtheMiddleEast

Thereareagreatnumberofthesesortsofagreements;somearemadebetween just twonations,givingeachotherpreferential statuswithoutothernationsgettinginvolved.Inaddition,asinglenationcanbelongto

manydifferentpreferentialtradeareas;itcantreatdifferentnationswithdifferentsetsofpoliciesdependingonwhichagreementitisapartyto,ifitisapartytoanyagreementatall.Not all preferential trade areas have exactly the same terms ofagreement. The only prerequisite for an agreement to providepreferentialtradestatusbetweennationsisthatitreducestheamountoftraderestrictionsforgoods,services,and/orcapital.Theagreementdoesnot have to eliminate any restrictions entirely, nor does it have toprovideanyspecificsaboutthetypesofrestrictionsbeingreducedortheamountofreductionsbeingmade.Aslongasthereissomepreferentialstatus in trade being given to the nations in agreement but notnecessarilytoothernations,andthereductionsintraderestrictionsarenot so great that the area should qualify to be labeled with somestronger form of economic integration, it is considered a preferentialtradearea.

WhyYouShouldCareSince each preferential trade area has its own rules by which themembernationsmustabide, the impact thateach tradeagreementhaswillvaryfromareatoarea.Willaparticularpreferentialtreatmenthelpaparticularsector, location,orbusiness? It’s impossible tosaywithoutfirstreadingthedetailsof theagreement inquestion.So, if there isnoset of standard benefits to a preferential trade area, why should youcare?Well,generallyspeaking,evenifthetermstoapreferentialtradeareadon’tdirectlyimpactyou,theeconomyasawholestillbenefitsbyincreasing resource efficiency, decreasing costs, and all the other goodstuffthatcomeswithtrade.

86.FREETRADEAREA

Ina freetradearea,all traderestrictionsareeliminated.Thosenationspartytoafreetradeareadon’thaveanytariffs,quotas,exportsubsidies,oranyotherrestrictionsonthemovementofgoods,services,orcapitalbetweennations.This does notmean, however, that people canmove freely between

thenations,althoughacertaindegreeoffreedomandexpediencyinthemovementofpeopleisoftenarequirementformakingthemovementofgoodsandcapitalefficient.Simplyput, ifa truckdrivercan’tcross theborder,thentheshipmenthe’sdrivingcan’tcrosstheborder,either.Theotherprimary featureof a free tradearea is that eachnation is

stillallowedtosetitsowneconomicpoliciesnotrelatedtothefreetradeagreement without coming to a consensus with the other membernations.Unfortunately,thiscancauseaconflictofinterestintrade.Forinstance,ifFreedoniawantstoplaceatariffonSylvania,butBrungariadoesnotwantthesametariffonSylvania,FreedoniaandSylvaniamayjoin as a free trade area. In that case goods from Sylvania can enterFreedonia duty-free by using Brungaria as an intermediary throughwhichthegoodsareimportedandthendistributedthroughoutthefreetradearea.

WhatYouShouldKnowAswithpreferentialtradeareas,therearealargenumberoffreetrade

areas that are based on geographic proximity between the membernations.Perhapsoneof themostwellknownof these free tradeareas,and certainly themostwidely recognized, is theNorth American FreeTradeAgreement(NAFTA).ThisisanagreementbetweenthenationsofCanada, theUnitedStates, andMexicoand is oneof the largest singletradeblocsintheworld,asmeasuredbyGDPofthemembernationsaswellasthevolumeandvalueofcapitalmovedacrosstheborders.TheimplementationofNAFTAin1994meantthatoverthecourseof

fifteen years, all tariffs and quotas on any goods, services, or capitalbeing traded or otherwise moved between the three member nationswereeliminated.Somerestrictions,however,remained.Forexample,theUnited States has a full embargo on all goods fromCuba, so althoughgoodsfromCubacanbefoundinbothMexicoandCanada,theydonotenterthebordersoftheUnitedStates,regardlessofthefactthatthey’repassingthroughanationpartytoNAFTA.

WhyYouShouldCareItisatthislevelofeconomicintegrationthatweseetheeconomiesof

countries rearrange themselves to their optimal balance of production

andtrade.Forexample,afterpassingNAFTA,manypartsoftheUnitedStateswentthroughaprocessofdeindustrialization:Alargeamountofcapital and industrial production left the nation because it could beperformed more efficiently in either Canada or Mexico. The traderestrictionsforthemembernationsofafreetradeagreementaresolowthat the natural equilibrium of economic forces reaches their optimalbalance. In other words, companies and people are free to searchbetween the nations of a free trade area for options to relocate theirbusinesses, outsource production, purchase supplies, sell their goods,makeinvestments,andallotherformsofeconomictransactions,sothatthe amount of supply and demand for trade between nations and theamount of output that each nation produces change to a significantdegree.Basically, people and companies are free to respond tonormaleconomic pressures as is most effective without governmentintervention.Whilethisprocessisgreatlybeneficialinthelongrun,itisnotalways

comfortable. It leads to the movement of people across borders,changingdemographicsofcapitalownershipineachnation(i.e.,fearsofmajorityforeignownership),andthemovementofunwantedgoodssuchasdrugsorweapons.Still,thesearealleventsthatoccuralready.

87.CUSTOMSUNION

Whenatradeblochasallthetraitsofafreetradeareabutthengoesastep further to unify and coordinate the trade policies of all membernations, it becomes a customs union. In other words, all the nationscollaborate to forma single set of trade policies adhered to by all themembers. The first requirement is that all trade must be free ofrestrictions in the same manner as a free trade area. The secondrequirement is that all the member nations treat other nations in thesameway.Since customs unions set their own domestic economic and trade

policies,nationstendtobefarlessenthusiasticaboutjoiningacustomsunion,andtherearefarfeweractivecustomsunionsthantherearefreetrade areas. This degree of political integration begins to reduce the

amount of sovereign control that a nation has over its own policies.Governments tend to resent having to reach a consensus with othergovernmentsbeforetakingaction.

WhatYouShouldKnowThose trade blocs that are customs unions, without involvement oroverlapwithmore integrated tradeblocs, are established among thosenations with smaller and more volatile economies. The two mostsuccessful and longest-living customs unions, CAN and Mercosur, areSouth American. CAN is the Andean Community, the oldest andcurrently the largest distinct customs union with a total of thirteenmembers (four full members and several outside members throughalternativeagreementsbetweenthosenationsandCAN,calledassociatemembers).Mercosurisabitnewerandsmallerwithonlyninemembernations (three fullmembers, fiveassociatemembers, andonemember,Paraguay,currentlysuspendedforpoliticalproblems).InAfrica,theEAC(EastAfricanCommunity)issimilartoCANinstructure.Customsunionstendtoconsistofnationswithverysmallorvolatileeconomies because these clusters of nations united by proximity willcooperate with each other for mutual benefit, particularly regardinginternational political and economic relations. They have similarcultures and similar goals, which allows them to work togethereffectively. By forming a customs union, these nations gain greaterinfluence, negotiating power, and a more unified message than anymembernationcouldhopetoaccomplishonitsown.In2005themembersofMercosurjoinedCANas“associatemembers.”MercosurisstillitsownentitybutitscoordinationwithCANcontinues.Thesetwogroups,ratherthanattemptingtopositionthemselvesrelativeto each other, found that they have similar goals and have begunworkingtogether,providingevengreaterinternationalsynergythroughcooperation and coordination of the economic policies and efforts oftheirmembernations.

WhyYouShouldCareCustoms unions must be looked at as a single agglomerative entityratherthanacollectionofindividualmembernations,asisthecasewith

freetradeareas.It’snotthatthesenationshavemergedtoformasinglelargenation;eachmembernationisstillrunbyasovereigngovernmentthat maintains nearly the same amount of control over domestic andinternationalpolicy.However,despitethefrictionthatmayoccurwithinthecustomsunionindecidingtradepolicy,thepoliciesthatformwillbeconsistent across all member nations. The nations become moreinterdependent on each other, working as pieces of a large economicmachineratherthansmaller,separatemachines.

88.COMMONMARKET

Thosetradeblocsthatallowforthefreeexchangenotonlyoftradeandthemovementof capital across internationalborders,but also the freemovement of people, are considered commonmarkets. This degree offreedomforallthefactorsofproductiontomovebetweennationsforms—forthepurposesofassetallocationand,toa largeextent, tradewithoutside nations— a single nation. Although the establishment of aunifiedsetofpoliciesregardingtradewithnonmembernationsisnotaprerequisite for a common market, its tendency to become a singleintegratedeconomicentityoftenhasthisendresult.

WhatYouShouldKnowCurrently the only trade bloc that is a commonmarket is the SouthAsian Free Trade Area (SAFTA), which includes a number of nationsalong the southern parts of Asia and theMiddle East. Other commonmarkets, though, provide better insight into the advantages anddisadvantagesofthistypeofeconomicformation.Forinstance,Canadaestablished a common market for its various provinces in 1995. Theindividual provinces in Canada are given a large degree of autonomy,and the establishment of a common market among them helped toimprove national cohesion and unity among the separate regions of asingle country. Across the Atlantic Ocean, several nations in northernEurope established a common market called the European EconomicArea (EEA), which allows them to participate in the European Uniontradeblocwithoutbecomingevenmoreintegrated.

WhyYouShouldCareCommonmarketsare themost economically integrated forma trade

bloc can take without actually requiring a consensus between nationsaboutsettingeconomicpolicies.Thesemarketssometimeshavesimilar,iflimited,policiesontradewithnonmembernations.Severaltradeblocsoflowerintegrationhavethegoalofeventuallyreachingthestatusofacommon market because of the perceived benefits associated withincreasing free trade integration while maintaining a high degree ofpoliticalindependence.

89.ECONOMICUNION

Thenextstepinachievingtotaleconomicintegrationistheformationofaneconomicunion.Thisentitycombinesthetraitsofcommonmarketsand customs unions. An economic union not only allows for the freeexchangeandmovementofgoods,capital,andpeopleacrossthebordersofthemembernationswithoutrestriction,butitalsodevelopsasingle,common set of policies regarding economic relationswithnations thatare not members of the economic union. However, members of theunionmaintaintheirindividualfiscalandmonetarypolicies.Eachnationcontinues to set itsownpolicies for taxationandexpenditures,and forthevalueandquantityofmoneyandinterestrates.Thisallowsthemtoappropriately respond to thedynamicsofglobal economics inorder tooptimizetheirowneconomicpotential.Atthesametime,theypresentaunited set of foreign economic policies consistent with the rest of theeconomicunion.

WhatYouShouldKnowMembersofaneconomicuniongraduallytransitiontoaunifiedsetof

foreigntradepolicies.Afterthistransitionphase,themembersarefullyintegrated into the union. Internally there is almost no differencebetween an economic union and a commonmarket. Economic unionssimply take that additional step to formalize the interdependenteconomic relationship that exists between its members. But even ifthere’s little practical difference, there are large cultural and political

obstacles in the way of such a union. Many nations prefer to remainindependentandferociouslyindividualistic.

WhyYouShouldCareRight now there are no multilateral trade blocs that can be called

economicunions.Mosteitherfall intothecategoryofmonetaryunionsorcommonmarkets.Still,thereareafewbilateralagreementsthatcomeclose to the description. Other less-integrated trade blocs intend tocontinue integrating until they become an economic union. Theseformationsandtheir functioningwillsoonbevery important fortrade,particularly indevelopingnations in SouthAmerica,Africa, andSouthAsia.

90.MONETARYUNION

Shortofmergingmultiplenationsintoasinglenation,theformationofamonetary union is as integrated as different national economies canbecome.Thereareonlytwomonetaryunionsintheworld:theEuropeanUnionandCARICOM.

1. CARICOM(CaribbeanCommunity)isamonetaryunionconsistingoftwenty-sevennations,mostlysmallislandcountriesintheCaribbeanbutalsowithahandfulofnationsfromCentralandSouthAmerica.

2. TheEuropeanUnion(EU)isamonetaryunionwithseveralspecialuniquetraits;itwillbediscussedingreaterdetaillaterinthischapter.

In addition to maintaining the free exchange of trade, capital, andpeople across international borders, and maintaining a single set ofeconomic policies regarding trade and capital movement withnonmembernations,monetaryunionsgoone step furtherandcreateacentralized body for the management of unified fiscal and monetarypolicy. In other words, all the member nations become, for economicpurposes,onenation.Whileeachnationdoesmaintainacertaindegree

of control over its fiscal policy (taxation andgovernment spending), itmustbealignedwithallothercountriesintheunionaswellasthegoalsof the monetary union as a whole. This presents a question: howintegratedistoointegrated?Thatistosay,atwhatpointdoesthelevelofintegrationthatnationsagreetobecomeahindrance?

WhatYouShouldKnowThroughoutthisbookI’veadvocatedfreetrade,butmonetaryunions,

by integrating large numbers of nations with such widely differenteconomies, can create problems as well. Nations need the ability toadapt.Let’s taketheexpansionofmonetaryunionstotheir logicalextreme:

the full economic integration of all nations on earth under a singlecurrency and a single monetary policy. The vast and ever-changingdifferences between nations require them to be able to respond bychanging the value of their currencies, inflation rates, monetary andfiscalpolicies,andotherpolicies,bothdomesticandinternational.Withcontinued integrationacross agreaternumberofnations, governmentslose the ability to alter exchange rates, to manage inflation andunemploymentrates,ortorespondproperlytoanychangeineconomicstatusbetween twonations.Simplyput,membersofamonetaryunionmustbeveryconfidentthattheirgoalsandeconomiccyclesarealigned.Otherwise the international economic pressures that they normallyexperiencewillcausesevereproblems.The issues experienced by monetary unions are the same as those

experienced by many nations managing their own internal economicissues.Oneproblemlies in theirattempt tobalancecentralizedcontrolover economic and trade policies with the fiscal policies set by theregional and local governments. The needs of individualstates/provinces/districts can be extremely difficult to manage whengovernments must also be responsive to the needs of the nation as awhole.Of course this isn’t impossible, but the struggles countries facearenotsodifferentfromthoseexperiencedbymonetaryunions.

WhyYouShouldCareTheeffectivenessofmonetaryunionshascomeunderheavydebatein

recentyears.Thebenefitsofeconomiccohesionbetweendifferentpartsofthesameeconomicbodyareverywellestablishedandcanbedirectlyseen as we look around our nation.Without the cooperation betweenthese individual parts of a single country, the discord would cause alargeamountofeconomicinefficiencies.Criticsofmonetaryunionsbecamemorevocal after the2007global

financial collapse. However, all the nations experiencing economicdifficultiesasaresultoftherecessionwouldhavebeenharmedwhethertheyweremembersofatradeblocornot.Membershipwithinthetradeblocwillallowthem,inthelongrun,tomoregreatlybenefitiftheycanlearn to effectively manage the differentials in local and bloc-wideeconomicresponses.Conflictofinterestwithinamonetaryunioniscausedbytheattempts

touseasinglesetofmonetaryandfiscalpolicies.ThepeopleofPortugalcan have very different needs than the people of Finland.While theyboth benefit from free trade, the requirement of coordinating a singlecurrencyorsetofpoliciescanbequitedifficult.

91.INVOLUNTARYINTEGRATION

Not all economic integration happens as the result of planned orvoluntaryagreementsbetweennations.Throughincreasedglobalization,markets and outputs spread across international borders regardless ofany policies. These trends are completely beyond the control ofindividuals,companies,orevengovernments.Probablythebestexampleoftradethatcontinuesdespitethemassive

efforts by governments around the world is the drug trade. The uglytruth is that it will continue, no matter what the governments of theworlddototrytostopit.Iftherearepeoplewillingtopaymoneyforaproduct, then therewill always be someonewilling to provide it. Theillegaldrugtrade,oneof thebiggest industries intheworld, integratestheglobewhetherwelikeitornot.Another example of involuntary economic integration involves the

Internet. The Internet allows exchanges in goods and services to occur

regardless of trade restrictions thatmay already be in place. It allowspeople to easily circumvent trade restrictions or external economicpolicies.

WhatYouShouldKnowMany nations have tried to increase trade restrictions and move

toward protectionist policies that limit both economic and socialactivities within their borders in an attempt to control the differentforms of involuntary integration. Often, these forms of integration areharmfulorunwanted—attheveryleastthey’reuncontrollable.Countriescanonlymanagethem.AsisthecaseinthedrugtradeandInternetexchanges,intheeraof

modernglobalizationthemorerestrictionsthatareplacedontrade,themore—paradoxically—we move toward an integrated system thatignorestraderestrictions.

WhyYouShouldCareNomatterwhereyoulive,yourcountryisintheprocessofincreasing

theamountofeconomicintegrationithaswithneighboringcountriesaswell as nations on the other side of the globe. As with any form ofeconomic integration, the free exchange of capital and ideas withoutgovernment intervention tends to be beneficial. So in the long run,integrationisinyourbestinterests.

92.EUROPEANUNION

The European Union is a special type of monetary union. Firstestablished in 1958 as a less integrated and much smaller trade blocconsistingofsixnations,theEUhascontinuouslyincreaseditsdegreeofintegrationaswell as its size.Currently it is themost integrated tradeblocintheworldwithtwenty-sevenmembernations.TheEUisalsothebiggest economy in the world, surpassing the United States by theequivalentof$2trillioninGDP.TheEuropeanUnionisafullmonetaryunionworkingunderasingle

setofmonetarypoliciesandusingasinglecurrency(theeuro);asingle

setoffiscalpolicies,whicharegivenacertainamountofdelegationtothemembernations;asinglesetoftradepolicies;andafreedomoftradeandmovementacrossthebordersofmembernations.Allthisbindstheentire region into a single organized economic entity. The EuropeanUnion has also taken steps that integrate political control as well aseconomiccontrol.Theindividualmembernationsstillmaintainthevastmajorityofpoliticalcontrol,includingallissuesnotspecificallyreferredto in the treaties set by the European Union, but they have anestablishedpoliticalbody,includingaparliament,council,courtsystem,andcentralbank,alldesignedtoundertakethosecross-borderissuesinadditiontoaspecificsetofintranationalissues,calledcompetencies.

WhatYouShouldKnowTheEUisthelargestandmostbroadlyreachingattemptateconomicintegration inmodernhistory.As a result, there ismuchwe can learnfromitabouteconomicintegration.ManynationsinitiallyresistedorhadquestionsaboutjoiningtheEU.Somevieweditasanopportunityforsmallerandlessdevelopednationstobenefitatthecostofmoredevelopednations.Certainlytheprocessofeconomic reorganizationwasnot an easyone; the locationsof specificcompaniesandevenentireindustriesshifted.Another issue has been the problem with establishing a singlecurrency, a single set of monetary policies, and a unified set of lawsregarding fiscalpolicyandbusiness regulation.Asmembersof theEU,these countries not only use a single currency but they also give upcontrol over monetary policy and a large portion of fiscal and tradepolicy. So, rather than being able to properly respond as a fullysovereignnationwouldtoglobaleconomicpressures,EUnationshave,at times,experiencednegativeconsequences that result fromnotbeingabletofullymanagetheirowneconomy.Does that mean that EU membership is a bad thing? No, since themembernationswillexperiencelong-termbenefitsthatexceedthecostsassociated with a lack of economic responsiveness. Still, the problemspersistandthoseopponentsofEUmembershiparelouderthanever.

WhyYouShouldCare

There is still a lot of controversy surrounding the EU, particularlyfollowing the 2007 financial collapse, and many nations are givingseriousconsiderationtoleavingtheunionoratleasteliminatingtheuseoftheeuroasaformofcurrency.ThesuccessorfailureoftheEUwillnotonlyhavealargeimpactontheeconomiesoftheentireworld,butwillalsoshapefutureattemptsatinternationalintegration.

CHAPTER10Development

This book began by explaining the motivations behind globalization,trade, and the exchanges and interactions that make up the globaleconomic systems. In this, the final chapter, we will discuss theconsequences of trade and global economic exchanges. We will talkaboutwhat happens as a direct result of global economic interactionsand increased globalization, what the gains from trade look like on aglobalscale,andwhathappenswhentradeoccurs.

93.GROWTH

The growth of population requires additional production to sustain itwhile also providing additional workers who contribute to thatproduction.Companies increase in size as theyprofit fromproduction,reinvesttheirprofitsinexpandingoperationsandnewtechnologies,andincrease their total production potential. These are the drivers ofsomethingcalledeconomicgrowth.Economicgrowth refers to the total change inproduction.Thereare

severalways tomeasure the value of a nation’s production,whichwecanthenusetomeasuregrowth.

Grossdomesticproduct(GDP)isthemostcommonmeasureofgrowth.GDPmeasuresthemarketvalueofalltheoutputthatisproducedwithinanationinagivenyear.Thatcanbeproductionbyforeign-ownedorganizationswithinanation;forexample,therearecompaniesownedbyforeignersoperatinginGermany,butthatdoesn’tmatterintermsofGermany’sGDPbecauseitmeasuresallproductionwithinthecountry’sborders.

Theotherprimarymeasurementforgrowthisgrossnationalproduct(GNP),whichmeasuresthevalueofalltheoutputproducedbyorganizationsownedbycitizensofasinglenation.Forexample,Germany’sGNPwouldbecalculatedbymeasuringthevalueofoutputbyallGerman-ownedcompaniesregardlessofwherethey’relocated.GDPandGNParen’tgrowthmeasures;they’rejustthemeasureofthevalueoftotaloutput.Anation’sgrowthisdeterminedbymeasuringtherateofchangeintheGDPorGNP.Ifanation’sproductionisincreasing,thenthenation’seconomyisgrowing.Ifanation’sproductionisdecreasing,thenthenation’seconomyiscontracting.

WhatYouShouldKnowIn global economics we talk about the relative growth betweennations, which leaves us in a bit of a quandary regarding how tomeasurethevalueofproduction.WeknowfromdiscussingcurrencyinChapter4that,forexample,thesameapplegrownindifferentcountrieswill have a different value depending on the exchange rate andpurchasingpowerof thedomestic currency ineachnation. Inorder tocompare growth rates between nations we need to adjust for bothcurrency values in order to “compare apples to apples” (pun fullyintended).Wehavetwoapplesof theexactsametype,size,andweight;oneofthe apples is grown in Canada, and the other in Romania. The applefromCanadaisworthCAD1andtheonefromRomaniaisworthEUR2.NotonlydoestheexchangeratebetweentheCADandEURinfluencethevalueof thatapple,but sodoes thepurchasingpowerparity (PPP).Sowhatwe do first is convert everything to a single currency. AssumingthattheexchangerateisCAD1=EUR2,thentheappleinbothnationscostsCAD1. In this particular examplewe’ll say that PPPbetween thetwonations is1to1,sonofurtheradjustmentsareneeded. If thePPPbetween the two nations was different we’d also have to adjust forRomania’s purchasing power to make sure the value of that apple isequivalentforbothnations.Wedoallthisbecausewhenwe’recomparingthetotalproductionoftwo nations, it’s not as easy as simply saying that one producedmore

applesthantheother.CanadaandRomaniaproducedifferentthings,indifferent quantities, with different traits. So in order to compare thegrowth of two nations we adjust for exchange rate tomake sure thatisn’tchangingthevalueofourcalculation,thenweadjustforPPP.Thefinalnumbershowswhichnationisactuallyproducingmoreorlessandbyhowmuch.

WhyYouShouldCareIn global economics, knowingwhich countries are growing faster orslower can help investors to better assess an investment’s potential. Itcanalsohelpnationsunderstandhowtoallocatetheirassetsandbettersettheirpolicies,andithelpseveryonetobetterpredictwhat’sgoingtohappenwithintheirownnation.Ifthevalueofanation’stotalproductionincreasesatthesamerateasitspopulationgrowth,thenitsgrowthpercapitawillremainthesame.Ifthe value of a nation’s production growsmore quickly ormore slowlythanitspopulation,thenthegrowthpercapitawillincreaseordecrease.As someone—preferably you—accumulates wealth, he or she canpurchasemoregoods tomake theirown lifemorecomfortable.This ishowincreasedgrowthpercapitatranslatestoincreasedqualityoflife.

94.DEVELOPMENT

Whereasgrowthseekstomeasuretheincreasedwealthavailabletothepeopleofanation,developmentreferstomeasuresofthequalityoflife.Thiscanbeasubjectiveissue,ofcourse,sincepeoplearoundtheworldtendtovaluedifferentthings.Before looking at the metrics for quality of life, we need to defineexactlywhatqualityof life is.Qualityof liferefers to theoverallwell-beingofanation’speopleanditscommunities.Basically,we’relookingtoestimatewhetherthepeopleofanationarehappyandsecureintheirlives.Aswemeasuredevelopment,anincreaseineachmetricismeantto indicate an improvement in the quality of life in a nation,while adecreaseinthemetricismeanttoshowalowerqualityoflife.

Severaldifferentindicesaregenerallyacceptedasprovidingsomeideaof a nation’s quality of life. The most commonly cited is theHumanDevelopmentIndex (HDI),whichusesaweightedaverage taking intoaccountmeasuresofhealth,wealth, andeducation.Another compositeindexthatusesamorecomprehensivesetofscoresistheQualityofLifeIndex (QLI).This indexwas establishedbyTheEconomist in2005andincludesninedifferentmetrics:lifeexpectancy,divorcerate,attendanceincommunityorganizations,GDPperperson,politicalstability,climate,unemploymentrate,politicalfreedom,andgenderequality.

WhatYouShouldKnowNational economic development is a much more difficult thing to

sustainthangrowth.Infact,mostmeasuresofdevelopmentincludeGDPper capita as only a single measure in the composite. The remaindercomesfromtheabilityofanationtousetheincreasedwealthtomakeavailabletothenation’speopleavarietyofservicescontributingtotheiroverall standard of living. This means infrastructure development; thedistribution of qualitymedical care and safety services such as police,fire,andmilitary;access toaneducation (even if that’scareer trainingratherthantraditionaleducation);environmentalrenewalinfrastructure;andaccesstoutilities.Generally speaking, increases in wealth tend to lead to increased

development. The reason that many nations have large deviations intheirlevelsofdevelopment,though,hasasmuchtodowiththeoriginalsourcesofeconomicdevelopmentaswithcurrentmodernsources.

WhyYouShouldCareWhileeconomicgrowthisimportant,contributinggreatlytothelives

ofanation’speople, theultimategoalofnations isdevelopment.First-andsecond-worldcountriesareseekingthesustainableindustrializationthat puts them on the road to becoming developed nations. Thedevelopment of a nationdetermines not only the quality of life for itspeople, but also its future potential. People who have the ability toinnovatewillimprovetheirnationbeyondwhatwaspreviouslypossible,but this only happens when they have the knowledge, physicalcapability, and resources to allocate to such an initiative. As a result,

development is what improves the world, while growth only makesdevelopmentpossible.

95.INCOMEDISPARITY

We’vetalkedseveraltimesnowabouthowpeoplegeneratewealthfromexchanges in goods and services, and how wealth can translate intoimprovements in national development. But wealth is not distributedequally. In any given nation, some maintain a larger share of wealththanothers.ThisincomedisparityismeasuredusingtheGinicoefficient.Thisisanumberbetween0–1thatmeasureswhatproportionofpeopleown what proportion of wealth. A Gini coefficient of 0, for example,means that income isdistributedevenlyacrossallpeople;1percentofthepeopleown1percentof the income,50percentofpeopleown50percent of the national income, and 99 percent of the people own 99percent of the income. At the other extreme, a Gini coefficient of 1means that the total national income is distributedperfectly unevenly;onepersonowns100percentoftheincome.Ofcourse,intherealworldthesetwoextremesareneverencountered.TheGini coefficient is usually expressed througha graph.A straightdiagonal line shows the theoretical perfectly equal distribution; aperfectly unequal distribution wouldn’t be seen because it just runsalongthebottomandfarrightsideofthegraph.What’simportantisthecurve illustrating the real national distribution of income, called theLorenz curve. The further away from the horizontal line that yournation’s Lorenz curve gets, the more unequal is your nation’s incomedistribution.

WhatYouShouldKnowWhethermaintaininganincomedisparityisagoodthingorbadthinghas been a matter of heated debate for centuries. It’s often led torevolutionsandwars,andtheexactamountofdisparitythat isseenasoptimal, if any, is a topic that has not been soundly established. Thedebate comes squarely on two primary issues: ensuring a fair andequitablecompensationorincentivesystem,andtheroleofinvestments.

In the first issue, regarding compensation,neitherplannedeconomicsystemsnormarket-basedsystemshavetrulyfoundaneffectiveanswer.Muchoftheproblemappearstobetheresultoftheabilityofthosewhomanagecapitaltoretainmuchgreaternegotiatingpowerthanthelabormarket(particularlyduringperiodsofhighcompetitionforjobs,suchasduring recessions), easily manipulate short-term financial information,andinfluencepolitics,regardlessoftheincentiveschemesandamountofcontrol(orlackthereof)established.Ontheothersideoftheargument,itissaidthatthevaluegeneratedbyhigh-incomeindividualsishigher,and the market responds appropriately. We know this to be false,however,becauseexecutive incomehas increaseddramaticallyevenasaveragecorporate financialperformanceandGDP fall,orotherwisedonotincreaseasquicklyasaverageexecutivecompensation.Regarding the use of the socioeconomic disparity, perfect equality

results inentrepreneurshavingfewerresourceswithwhichtoinvest inbusinesses, innovations, and other economic growth projects. Perfectinequality implies that no one is beingproperly compensated for theirresources.Thebalanceis,ofcourse,foundsomewhereinthemiddle.

WhyYouShouldCareAllcompaniesaroundtheworldstayinbusinessonlybecausepeople

havetheresourcestopurchasetheirgoods.Thesocioeconomicdisparityisnotanideologicalissue;it’smerelyanissueofmanagingsupplyanddemand.Decreasingthesocioeconomicdisparityandtherebyincreasingtheamountofmoneythatpeoplehavewillincreasetheamountofgoodsthatpeoplewanttopurchase,increasethenumberofpeoplethatwillbetaxed,increasetotaltaxrevenues,andstimulategrowth.Increasingthesocioeconomic disparity increases the amount of assets available toinvest in a company’s search for returns on investment, improvinginnovationanddevelopment.Theexactbalanceisaverycarefulonetomanage, but it is one that is all too often looked at in extremeideologicalterms.

96.DEVELOPEDANDDEVELOPINGNATIONS

In terms of their development, nations are divided into three primarycategories: developed, developing, and least developed.Developed anddevelopingnationsarenotsodifferentfromeachother,thoughthey’reat different phases in their process of modernization. Because of this,we’llconsiderboththesecategoriestogether.The exact criteria by which nations are evaluated to determine

whether they’re developed or developing is an issue of contention. Inmany cases it can be quite clear, particularly when comparing a verydevelopednationlikeGermanytoamuchlessdevelopednationsuchasRomania, which is still struggling to industrialize. The exact point atwhich a nation changes from developing to developed (or, inunfortunatecircumstances,fromdevelopedtodeveloping)isnotentirelyclear,though,asthereisnosingleagreed-upondivision.Still,theseareall semantics. When looking at the difference between developed anddevelopingnations,whatismorehelpfulistheprocessofdevelopment.Thinkofdevelopment as abit like thehuman life cycle.Developing

nationsaregrowinganddeveloping,oftenveryquicklyandfrequentlyinan awkwardmanner duringwhich time the nation struggles to defineitself and its role in the greater global context,working to establish astableeconomicidentity.Developednationsarethosethatareconsideredtobemature.They’ve

reached a point where they no longer rely exclusively on an absoluteadvantageintheformofcheaplaborortheconsumptionoftheirnaturalresources. They’ve established some industrialization in industries inwhichtheyhaveacomparativeadvantage,yet they’vediversified theireconomies enough to maintain reasonable economic stability. Thegrowth of their production and income has achieved an easilymanageablerate,andtheyhaveestablishedaninfrastructureconsistentwithimprovedqualityoflife.

WhatYouShouldKnowTerms such as “first-world nation” and “third-world nation” are

declininginpopularity,buttheycanstillbeuseful.Afirst-worldnationis a developed nation; a second-world nation is developing. There issomecriticismregardingtheuseoftheterm“developing”nation,sincemanyarguethatitimpliesinferiority.Sotoclarify:Adevelopingnation

ismerelyonethatisatadifferentstageinitseconomicdevelopment.Theageofacultureorhowlongapeoplehavebeenestablishedinageographicareahasnobearingoneconomicdevelopment.Theageofanationcan,however,influencetheextenttowhichasocietyispoliticallystable,aprimaryprerequisitetoeconomicdevelopment.ExamplesofdevelopednationsincludeJapan,Sweden,Italy,Taiwan,andBritain.ExamplesofdevelopingnationsincludeChina,Brazil,India,Mexico,andtheCzechRepublic.

WhyYouShouldCareUnderstanding the traits of developed and developing nations isimportant to grasp the role of each nation in the global economy.Businessesandinvestorslooktodevelopingnationsasplacesinwhichtoexpandoperations.Developmentaleconomistsandgovernmentofficialslookathowdevelopednationsachievedtheirstatusasaguideforhowothernationscandothesame.Yourexposuretoaparticularcultureorthe availability of goods and services frommany nations will dependgreatly onwhether that nation has reached a point of development inwhichsustainableandstabletradecanbeestablished.

97.LEAST-DEVELOPEDNATIONS

In contrast to developed and developing countries, least-developednations (LDNs) are those that have not yet begun industrialization orwhere it isweak and faltering.Often these nations rely exclusively onthe extraction of natural resources (mining, oil, natural gas, etc.) andsubsistence farming (in which the people of a nation survive byproducing their own foods and goods rather than by trading). LDNsusually have very low (or no) income per capita, low levels ofinfrastructure in such areas as transportation and utilities (much lesseducationandhealthcare),politicalandsocialinstability,andeconomicvolatility. These result from the inability of the nation to begin thoseprocessesofcapitalmovementdescribedinChapter8.Industrialization and urbanization tend to occur only temporarily

throughprojects fundedby foreigners.Once theprojects are complete,fledgling cities often experience rapid growth followed by devastatingurbandecay.Considerthecaseof thePanamaCanal.Thisconstructionproject brought in a huge number of jobs and increased prosperitywithin Panama. Once the canal was complete, though, the jobsdisappeared and the cities built on the wealth of this project quicklysankintodecrepitude.LDNsarealsoknownasthird-world,preindustrial,oragrariannations.Examples include Madagascar, Nepal, Haiti, Sierra Leone, and NorthKorea.

WhatYouShouldKnowReasons for the difficulty in development in LDNs generally comefrom two sources: natural hurdles andnational instability.Most of theLDNs in theworld suffer from challenges of location.Often they’re inplaceswith few inlandwaterways, lowrainfall, aprevalenceofdeadlydiseases such as malaria, or extreme geographic features such asmountainous terrain. National instability refers to not only economicinstability, but also social and political instability. LDNs often sufferfromalackofdiversificationinthenation’sindustries,leadingtoseverefluctuationsinsupplyanddemandforitsgoodsandleadingtodramaticperiods of unemployment. This puts a nation’s currency at risk ofexchange rate fluctuations, contributing to its questionable value as aunitofexchange.Socially, instability can refer to conflicts between people (usuallytribalorreligiousgroups),xenophobia,anddecisionsbasedonculturalsuperstitions.An inability toestablisha singlegovernment isoften thesinglelargestbarriertofutureattemptsatdevelopment.Thiswasahugeproblem in Myanmar (a.k.a. Burma) for decades, as an oppressivemilitaryjuntastoppedanydevelopmentfromoccurring.

WhyYouShouldCareIt is in theworld’s least-developed nations thatwe find the greatestamountof economicpotential.Peoplearound theworldhave spentanimmense amount of resources trying to stimulate sustainabledevelopmentintheseareas.ThroughoutpartsofAfricaonecanstillfind

the remains of portions of railroad track where foreign investors,businesses, and nations workedwith local people and governments toestablish a transportation infrastructure. Burdened by high costs, thedangersofdisease,andtherisksoflocalviolence,manyoftheseprojectswereeventuallyabandoned.Anotherunfortunatesideeffectof theattempts to industrializemany

LDNs has been a growth in national debt. Nations are given loans forinfrastructure development, and individuals are given loans to startbusinesses.These loansareeconomictrapsthatputpeopleandnationsunderthecontrolofforeignnationsandbanks.Asaresult, theseloansoftenendupharmingthedevelopmentprocess.

98.THENORTH-SOUTHGAP

Alinehasbecomeapparentthatseparatesdevelopednationsfromleast-developed nations. The equator acts as a sort of informal geographicborderthatdefinesthetrendsineconomicgrowthanddevelopmentforthenationsoneithersideofit.Onthenorthsideoftheequatorliethevastmajorityofdevelopednations;nationsnorthoftheequatortendtohave much higher rates of growth and development. South of theequator one finds the vast majority of least-developed nations. Thiseconomic variation along equatorial lines is referred to as the North-SouthGap,ortheNorth-SouthDivide.

WhatYouShouldKnowThecausesof theNorth-SouthGaphavebeendiscussed formuchof

the past century. Needless to say, there was a significant amount ofnonsenseinthebeginning,someofitrelatedtogeneticsandrace.Todayit’sgenerallyacceptedthatthedifferenceistheresultoftwoinfluences:differences in the original sources of development from prehistorictimes, and a lack of growth and trade resulting from those difficultiesthatleadstothevariousformsofinstability.We’lldiscusstheoriginalsourcesofdevelopmentinthenexttopic.For

now I’ll just say that thenatural resourcesavailable topeopleprior totheBronzeAgestillplayagreatroleinthedegreeofdevelopmenteach

nationexperiencestoday.Alackofresourcesresultedinaninabilitytotrade. As people spent all their time working in order to survive, nosurplusescouldbeestablishedwithwhichtotradeforothergoods.This,in many regions, stopped economic development before it could evenbegin.Regarding the secondprimary source, instability continues tohinder

development(seeprevious).Thosepeoplewhocanaffordtodosowillgotomoredevelopednationsseekingopportunities.Thisemigrationofskill and resources also helps to maintain the divide between globalnorthandglobalsouth.

WhyYouShouldCareOn a global scale we are still very far from reaching our total

economic potential. There is yet much more we can accomplish inincreasing the growth anddevelopment of every nation on the planet,even developed nations, by establishing a set course of developmentamong LDNs, particularly in those nations in the global south, whichlack the resources or ability to begin the development process. Inaddition, this inequitable distribution of wealth and development hasresulted in a number of human rights concerns that would be bestresolvedassoonaspossible.

99.SOURCESOFDEVELOPMENT

Thereasonthatsomenationsareeconomicallydevelopedandothersarenot canbe exploredby lookingat theoriginal sourcesofdevelopmentand how they benefited the people of a particular country. Economicdevelopment throughout history has relied heavily on the inputs ofproduction.AswediscussedinChapter1, thosenationsthat findwaystocreateproductioninexcessofwhattheywilluseareabletotradethesurplusforothergoods;bothnationspartytothetradewillbenefit.Nowtakethatideaofinternationaltradebetweennationsandshrink

it down to the trade between communities in a single nation, or evenbetween individuals within a single community. Gains from tradecontinue to generate wealth as long as they allow participants to

producemoretogetherthantheycouldontheirown.Today, thanks to the increasedaccess thatpeopleallover theworld

have to the factorsofproduction, therearea largenumberofways tomakethishappen:

Sharingofproductionmethods

Involvementfromforeigninvestors

Foreignaid

Internationalcorporateexpansion

However,themoderndistributionofwealthanddevelopmentaroundtheworldisnotsodifferentfromthatoftheancientworld.Peoplewereoriginallyable tocreate these setsof circumstancesprimarily from thenaturalresourcestheyfoundaroundthem.Naturalresourcesdifferfromcountrytocountry;theplantsthatgrow

in each, the animals, climate, minerals, physical geography—all aredifferent. It is also possible, though, to find similarities betweendevelopednationsandundevelopednations.Studying thesesimilaritiesand differences and their evolution over time contributes to ourunderstandingofeconomicandsocialdevelopment.

WhatYouShouldKnowThe pursuit of those products andmethods that increase production

yields iswheredevelopmentbegan.Wheneveryone inacommunity isdedicating all their time to producing food (gathering, hunting,processing, preserving, etc.) to stay alive, people aren’t producingtradablesurpluses,theyaren’tproducingothertypesofgoods,andtheycertainly aren’t developing. For example, many indigenous people ofsouthern Africa and parts of southeast Asiawho rely heavily on palmtreesfortheirfoodandbuildingsuppliesfinditdifficult toaccumulatesurpluses. The reason is that palm trees are very time-consuming toprocess into food and building supplies; they also have relatively lownutritionalvaluecomparedtoothercrops.Let’scontrastthatwithahigher-yieldproduct:corn.Likepalmtrees,

nearlyeverypartofthecornplantcanalsobeused,butunlikethepalm

tree,corngrowsmuchmoreeasilyandquickly.Itproducesmoreediblematerialperacre,takeslessefforttoprocess,andismorenutritious.Asa result, a single person can produce corn for a very large number ofpeople,allowingthoseotherpeopletodedicatetheirtimeandeffortstosomethingotherthanproducingfood.Therealdifferencebetweenthesetwocircumstancesisn’ttheknowledgethatcornmakesbetterfoodthanpalm trees; it’s simply that palm trees grow naturally in some areaswhilecorndoesnot.Ifpalmistheonlything,thenyou’rehavingpalmfordinner.So,plantsthatgrowinaparticularareaplayalargepartintheregion’sdevelopment.Thesamecanbesaidfortheanimalsthatareindigenoustodifferentareas.Nationalgeographyalsoplaysanimportantfactor.Manynationshave

a very difficult time developing because of a severe lack of water orwaterways.Australia,forexample,isdevelopedonlyaroundthecoasts.Sincethecontinenthasnoinlandwaterwaysthatpenetratedeepintotheinterior,thevastmajorityofthenationiscompletelyundeveloped.The availability of mined goods within the earth has also been a

primary contributor to the origins of development. During the CopperandIronAges,peoplebeganrelyingheavilyonthesemetalsasamoreeffectivematerial for tools.Regions that lackedthesematerialsdidnotmakethisleapforward.

WhyYouShouldCareMuch of the development experience in the United States occurred

whencropsandgrowingmethodsusedbyNativeAmericanswereusedincombinationwiththeproductionmethodsanddomesticatedanimalsbroughtby theEuropean settlers.What this tellsus is that stimulatingdevelopment innationsaroundtheworldcanproducedramaticresultswhen we understand the process better. However, we must proceedcautiouslyandlearnfrompastmistakesinthisarea.

100.URBANRENEWAL

Urban areas—even entire nations—can be subject to decay and otherformsofeconomicdilapidation,butthat’sreallynottheendofthestory.

Such disaster areas often go through a process of revitalization calledurban renewal. This is the process of re-establishing growth anddevelopmentinapreviouslydecayedarea.The process combines city planning with economic stimulus

initiatives.Theultimategoalisthreefold:

1. Theareamustonceagainattractinvestmentsfrombusinessesandentrepreneursseekingtobeginbusinessoperations,therebyrevitalizingindustrializationorpostindustrialmanufacturing.

2. Anyrenewaleffortmustattractindividualsbymakingthecityadesirableplaceeithertoliveinorvisit.

3. Thecityornationmustbecomeeconomicallysustainableandefficient.

Theserenewaleffortsmustusuallybeginearlyinthephasesofdecay,while the city is still generating enough revenues to invest in therenewal process. Renewal is a very expensive initiative and if a citywaitsuntiltheproblemgetsoutofhand,itmaynotbeabletogenerateenoughrevenuestopayforit.Detroit,Michigan,isaperfectexampleofthis. Several community-based initiatives have been attempted, butwithoutcitysupporttheyaren’tenoughtocombatrampantdecline.

WhatYouShouldKnowThe idea of urban renewal is a relatively new one, and many failedexperimentshaveoccurred,allwithgoodintentions,ofcourse.Herearesomeofthemoresuccessfulprojects:

MixedPurposeDistricts.Asingledistrictcanincludecommercial,industrial,andresidentialuse.Thistendstodecreasevehicletrafficbyeliminatingtheneedtotraverselargerareastogettoyourintendedlocation.

MixedValueHousing.Ratherthanhavingupscalehousingregions,low-priceddistricts,andentireneighborhoodsdedicatedtosubsidizedhousing,communitiesshouldincludemixed-valuehousing.Thishelpstomaintainamoreevendistributionofrevenuesandexpendituresacrossanentirecityandincreases

overallcommunityinvolvementandinteraction,improvingmaintenanceratherthanforcinglow-incomeareastofallintodecay.

Pedestrian-FocusedPlanning.Moderatetolargeareasdedicatedtopedestriantrafficdecreasevehiclereliance,whichinturndecreasespollutionandminimizestheneedforexpensivepublictransportation,improvesaccessibility,andincreasescommunityinvolvementandpublicinteraction.Thisalsoimprovespublicsafetybymaintainingahigherproportionofinterpersonalcommunicationandaccountability.

Revitalization.Publicartprojects,community-basedbeautificationprojects,refurbishinghistoric/culturalspots,demolishingblightedbuildings,andtheadditionoflandmarkssuchasfountainsorstatuesallhelptoimproveoverallmorale,decreasecrime,andincreasecommunitypride.

CommunityInvolvementandSafety.Initiativesforneighborhoodwatchprogramstoensurethesafetyandsecurityofpeopleminimizeflightofpopulationandcapital.

PublicFacilities.Centrallylocatedparks,publicrestrooms,publicdrinkingfountains,andothercontributionstopublicspacesareamust.Peopleshouldfeelsafeandwelcomeinthem.

FreewayPlanning.Ensuringthatthecityincludesbothroadsandpedestrianareasiscritical;freewaysshouldmergeintoroadsbythetimetheyenterthecityitself.

GeographicConsolidation.Urbansprawlspreadspeopleoutoveramuchgreatergeographicarea,includingmultipledifferentcitiesandtheirrelatedsuburbs.Consolidatingurbanandsuburbanareashelpstodecreasepollution,decreasedependenceonvehicles,andmaintainahealthydistributionofresourceswithinasingleregion.

Someofthemoresuccessfulprojectshaveincludedeffortstodiversifyindustries within a city, provide tax advantages for organizations thatemploylargerquantitiesofpeople,andfacilitateopeningnewandsmallbusinesses.Thefederalgovernmentalsogivespreferenceinitscontractsto companies that operate out of HUD (Housing and Urban

Development)zones.

WhyYouShouldCareTheentireprocessofurban renewal is to improvea city inorder toattractpeople,businesses,andinvestorsfromotherregions.Theintentistoincreasethecity’stradegravitytoattractproductionandtradefromother areas.Details of cityplanningand communityorganizationhavegiven important insights into the nature of development itself. Byutilizingmanyofthesamemethodsusedbyurbanrenewingplannerstodrive influxes of investment, production, and population, nations candirect their own planning with the goal of modernizing their nations,startingwithindividualcitiesandexpandingtootherareas.

101.INFLUENCEOFMULTINATIONALENTERPRISES

In the twenty-first century, multinational enterprises have anunprecedented amount of influence over the global economy. Eachcorporationnotonlymaintainscommandoveramuchlargervalueandvolumeofassetsaroundtheworldbutalsohasadegreeofnegotiatingpower and experience unheard of throughout history. This influenceexhibitsitselfinmultipleways,notallofwhicharegood.The desire of nations to attract investments and companies for thepurposeof stimulating economicgrowthanddevelopmentwithin theirnationhasledmanygovernmentstoeitherneglectorchangeestablishedlaws.Suchchangesoftencreatepoorworkingconditions,damagetotheenvironment,orpoorconsumersafety.For example, many electronics recycling companies in South Asiaforcetheiremployeestostriptoxicbutusefulmetalsfromoldelectronicsshippedtherebyforeigncompanies.Therestofthedeviceisofteneitherburned—releasingtoxicchemicalsintotheair—ordumpedintorivers.

WhatYouShouldKnowThese problematic business practices are not the result of some bigconspiracy to destroy humanity. They are the result of poor decision-makingthatstemfromthedesireofbothbusinessesandgovernmentsto

develop themselves, even at the expense of other stakeholders. Thedecisions are not always easy ones, and some that are consideredunethical have benefits that truly are quite valid. Some of these poorscenariosareunethical,butmanyaresimplemistakes.

WhyYouShouldCareIn recent years, companies with business practices that would bedeemed unacceptable in their home nations, as well as the foreigngovernmentsthatdonotenforcerestrictionsagainstsuchpractices,havecome under fire. This has resulted in a number of boycotts, fines andotherpenalties,andageneralincreaseincorporatesocialresponsibility.It is now considered strategically unfavorable to pursue financialefficiencyat thedetrimentofotherstakeholders.Thosecompanies thatmaintain high-quality, ethical operations, even in foreign nations, arethosethatexperiencegreaterfinancialperformanceinthelongrun.

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