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October 31, 2008

A New Global Shock Absorber

The dramatic increase in multinational production has realigned aggregate risk on a global scale, buffering firms and nations from shocks.


Trade — goods produced by firms in one country that are bought and shipped to another country — has long been the measure by which the scope of globalization’s costs and benefits are understood. Professor Veronica Rappoport, whose current research focuses on monetary and fiscal policy in emerging economies, suggests that examining multinational production (MP) — in which, for example, an American firm opens an affiliate in Mexico and produces shoes in Mexico to sell in Mexico — is an important and similarly informative means of understanding globalization.

Multinational production has been increasing dramatically since the 1980s. “Trade is important,” Rappoport says, “but sales by multinationals has been increasing faster than trade.”

Why does it matter whether goods are exchanged through trade or MP? “The fact that we are changing where production takes place is reshaping the whole pattern of world shocks,” Rappoport explains. “So it is not trivial whether it is through trade or MP that we choose to serve foreign markets.”

While much of the attention directed toward MP focuses on the consequences of the ongoing increase in outsourcing, outsourcing is not the main force driving the increase in MP. “Most MP that originates from U.S. companies is not, for example, in China trying to capitalize on cheap labor, but in Europe trying to get access to European markets,” Rappoport says. It’s this access-driven MP that Rappoport, working with colleague Natalia Ramondo of the University of Texas at Austin, sought to understand better.

In the past, MP was considered in terms of the firm’s incentive: is it good for the firm to open an affiliate or to trade, and which is better? The researchers did the opposite, combining data from U.S. national accounts (a measure of total national economic activity) in a model of the global economy to understand how trade and MP impact aggregate risk.

Rappoport and Ramondo found that the increase in MP spreads out risk more evenly between nations and that this diffusion of country-specific risk effected by increased MP creates more incentives for firms and nations to pursue FDI (foreign direct investment). Put another way, MP acts much like a shock absorber.

As a central player in the global economy, production or consumption shocks that affect the United States almost always result in shocks to world. Ideally, other countries compensate by moderating large fluctuations. “Of course, we can’t rearrange the world just like that, and ask China to produce more or consume more to make up for that,” Rappoport says. “But this is precisely what multinationals do.”

Multinational production moves production toward nations whose business cycle helps compensate when a big economic engine must weather a bad shock. For example, when a firm from a large economy with a significant industrial concentration in the electronics industry moves some production to moderate-sized economy with a weak concentration in electronics but a strong base in machinery, the large economy increases its risk insurance should it experience a decrease in domestic production or consumption.

“You can have perfectly integrated financial markets and you can do everything to hedge risk in the most efficient way,” Rappoport says, “but you still find that U.S. firms are going to have more incentive to relocate their production in economies where their risk is actually complementary to the United States.”

One conventional assumption is that the intertwining of markets through globalization has increased sensitivity to shocks large and small, but Rappoport’s work suggests reason to take a more optimistic view. “As globalization enables moving some production abroad, it reshapes risk patterns, many countries become less susceptible to bad hits from shocks.”

Veronica Rappoport is assistant professor of finance and economics at Columbia Business School.

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