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2005 Annual Report—Federal Reserve Bank of Dallas

Racing to the Top: How Global Competition Disciplines Public Policy

All over the world, consumers are getting more of what they buy from other countries. Since 1987, exports have jumped from 16 percent to 27 percent of the global economy.

More investors are prowling the world for higher returns. Since 1990, foreign direct investment has nearly tripled and cross-border portfolio investment has risen fivefold as a percentage of world output.

More people than ever are venturing abroad. The number of international tourists per 100 people has doubled over the past two decades.

The far corners of the globe are now plugged in. International telephone calls, mobile phone subscribers and Internet users have skyrocketed in the past decade.

These are but a few of the telling signs of a more interdependent and interconnected world, all reflecting the economic reality of our times—globalization. Political and geographic borders are less of an economic barrier as goods, services, people and ideas move more freely across international boundaries. (See Exhibit 1.)

The United States and other countries have benefited significantly from globalization. It has meant increased competition—which is good. Competition sharpens the wits and improves muscle tone. Facing foreign competition head-on keeps countries at the forefront of the global economy by encouraging businesses to do what they should do: create jobs and profits in a virtuous cycle that goes on indefinitely.

Consumers gain from lower prices and greater variety. A trip to any supermarket or discount store gives testament to the benefits of globalization: bananas from Ecuador, fresh-cut flowers from Colombia, low-priced dolls and games from China, coffee from Vietnam, software from Estonia, big-screen TVs from Taiwan.

Like technology, globalization unleashes the forces of creative destruction, a process described by economist Joseph Schumpeter more than 50 years ago. Some industries advance. Others recede. Jobs are gained and lost, businesses boom and bust, but economies emerge from the crucible more efficient, more productive and more wealthy.

The economic shifts make globalization a hot-button issue. In many parts of the world, protesters blame it for job losses as well as cultural and environmental degradation. Critics clamor for protection from globalization, pleading with their governments for new restrictions on global trade and investment.

Advocates of freer markets and further globalization emphasize the gains generated by an increasingly integrated world economy. They argue that open borders not only intensify competition but also encourage specialization.

Competition and specialization fuel economic progress. The most globalized nations lead their less open rivals in such measures as living standards, growth and job creation, while the poorest usually have the fewest ties to the world economy.

This is where most commentaries on globalization end—tallying the efficiencies gained in the private sector.

What about the public sector? There, too, globalization pays dividends through the competition it generates. An examination of key policies in 60 nations shows a strong correlation between globalization and policies that shape nations' economic performance.

Lowering barriers loosens the hold nations have on the capital, labor, businesses and know-how that create wealth. Increasingly mobile factors of production shun bureaucratic restrictions that lock them into outmoded methods. They avoid intrusive governments that hamstring their ability to adapt to a rapidly changing economy. They look for maximum returns on capital and the lowest tax burden on the sweat of the brow.

The more freely these factors of production can move across borders, the greater governments' incentive to pursue policies that will attract and retain valuable resources. In a globalizing world, countries win by instituting better policies and lose by overburdening their economies with taxes, regulations, trade barriers and policy instability.

The notion that competition between governments and factor mobility lead to better policies shouldn't surprise many Americans. This is our history. Tax and regulatory policies have always differed across the 50 states, spurring capital, labor and businesses to migrate in search of the best place to settle.

In the 1950s, American economist Charles Tiebout saw competing jurisdictions as a corollary to markets. If companies and workers could vote with their feet, it would pressure governments to provide services more efficiently and effectively. Just as Adam Smith's invisible hand directs the private sector to meet consumers' desires at lower prices, competition leads the public sector to policies that reflect people's needs and wants. Contemporary economists Geoffrey Brennan, James Buchanan, Dwight Lee and Richard McKenzie have also analyzed how factor mobility shapes public policy.

Globalization's critics charge that a more open world economy sets off a race to the bottom by encouraging nations to jettison protections for consumers, workers and the environment. Proponents contend that globalization prompts a race to the top by pushing countries toward policies that promote faster growth, lower inflation, higher incomes and greater economic freedom.

Exhibit 1

Going Global—Goods to Gigabytes

Globalization has been advancing as countries open markets and adopt new technologies. Trade is up. Both portfolio investment and foreign direct investment have surged. More tourists are crossing borders. International telephone lines, cell phones and Internet connections make access to information easier and cheaper.

World trade