The Retreat of Financial Globalization?

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Eight years after the global crisis of 2008-09, its reverberations are still being felt. These include a slowdown in world trade and a reassessment of the advantages of globalization. Several recent papers deal with a decline in international capital flows, and suggest some reasons for why this may be occurring.

Matthieu Bussière and Julia Schmidt of the Banque de France and Natacha Valla of CEPII (Centre d’Etudes Prospectives et d’Informations Internationales) compare the record of the period since 2012 with the pre-crisis period and highlight four conclusions. First, the retrenchment of global capital flows that began during the crisis has persisted, with gross financial flows falling from about 10-15% of global GDP to approximately 5%. Second, this retrenchment has occurred primarily in the advanced economies. particularly in Europe. Third, net flows have fallen significantly, which is consistent with the fall in “global imbalances.” Fourth, there are striking differences in the adjustment of the various types of capital flows. Foreign direct investment has been very resilient, while capital flows in the category of “other investment”—mainly bank loans—have contracted substantially. Portfolio flows fall in between these two extremes, with portfolio equity recovering much more quickly than portfolio debt.

Similarly, Peter McQuade and Martin Schmitz of the European Central Bank investigate the decline in capital flows between the pre-crisis period of 2005-06 and the post-crisis period of 2013-14. They report that total inflows in the post-crisis period reached about 50% of their pre-crisis levels in the advanced economies and about 80% in emerging market economies. The decline is particularly notable in the EU countries, where inflows fell to only about 25% of their previous level. The steepest declines occurred in the capital flows gathered in the “other investment” category.

McQuade and Schmitz also investigate the characteristics of the countries that experienced larger contractions in capital flows in the post-crisis period. They report that inflows fell more in those countries with higher initial levels of private sector credit, public debt and net foreign liabilities. On the other hand, countries with lower GDP per capita experienced smaller declines, consistent with the observation that inflows have been curtailed more in the advanced economies. In the case of outflows, countries with higher GDP growth during the crisis and greater capital account openness were more likely to increase their holdings of foreign assets.

Both studies see an improvement in financial stability due to the larger role of FDI in capital flows. Changes in bank regulation may have contributed to the smaller role of bank loans in capital flows, as has the diminished economic performance of many advanced economies, particularly in the Eurozone. On the other hand, smaller capital flows may restrain economic growth.

While capital flows to emerging markets rebounded more quickly after the crisis than those to advanced economies, a closer examination by the IMF in its April 2016 World Economic Outlook of the period of 2010-2015 indicate signs of a slowdown towards the end of that period. Net flows in a sample of 45 emerging market economies fell from a weighted mean inflow of 3.7% of GDP in 2010 to an outflow of 1.2% during the period of 2014:IV – 2015:III. Net inflows were particularly weak in the third quarter of 2015. The slowdown reflected a combination of a decline in inflows and a rise in outflows across all categories of capital, with the decline in inflows more pronounced for debt-generating inflows than equity-like inflows. However, there was an increase in portfolio debt inflows in 2010-2012, which then declined.

The IMF’s economists sought to identify the drivers of the slowdown in capital flows to these countries. They identified a shrinking differential in real GDP growth between the emerging market economies and advanced economies as an important contributory factor to the decline. Country-specific factors influenced the change in inflows for individual countries, as economies with more flexible exchange rates recorded smaller declines.

In retrospect, the period of 1990-2007 represented an extraordinarily rapid rise in financial globalization, particularly in the advanced economies. The capital flows led to increased credit flows and asset bubbles in many countries, and culminated in an economic collapse of historic dimensions. The subsequent retrenchment of capital flows may be seen as a return to normalcy, and the financial and banking regulations–including capital account controls–enacted since the crisis as an attempt to provide stronger defenses against a recurrence of financial volatility. But the history of finance shows that new financial innovations are always on the horizon, and their risks only become apparent in hindsight.

Capital Flows and Financial Crises

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The impact of capital flows on the incidence of financial crises has been recognized since the Asian crisis of 1997-98. Inflows before the crisis contributed to the expansion of domestic credit and asset booms, while the liabilities they created escalated in value once central banks abandoned their exchange rate pegs and their currencies depreciated. More recently, evidence that foreign direct investment lowers the probability of financial crises has been reported. A new paper by Atish R. Ghosh and Mahvash S. Qureshi of the IMF investigates how the different types of capital flows affect financial stability.

The authors point out that capital inflows can be problematic when they lead to appreciations of real exchange rates and increases in domestic spending. The empirical evidence they report from a sample of 53 emerging market economies over the period of 1980-2013 does show linkages between capital inflows on the one hand and both GDP growth and overvaluation of the real exchange rate. But when the authors distinguish among the different types of capital inflows, they find that FDI, which has the largest impact on GDP growth and the output gap, is not significantly associated with overvaluation. Net portfolio and other investment flows, on the other hand, do lead to currency overvaluation as well as output expansion.

Ghosh and Qureshi investigated next the impact of capital flows on financial stability. Capital inflows are associated with higher domestic credit growth, bank leverage and foreign currency-denominated lending. When they looked at the composition of these capital flows, however, FDI flows were not linked to any of these vulnerabilities, whereas portfolio—and in particular debt—flows were.

Ghosh and Quershi also assessed the impact of capital flows on the probability of financial crises, and their results indicate that net financial flows raise the probability of both banking and currency crises. When real exchange rate overvaluation and domestic credit growth are included in the estimation equations, the significance of the capital flow variable falls, indicating that these are the principal transmission mechanisms. But when the capital flows are disaggregated, the “other investment” component of the inflows are significantly linked to the increased probabilities of both forms of financial crises, whereas FDI flows decrease banking crises.

The role of FDI in actually reducing the probability of a crisis (a result also found here and here) merits further investigation. The stability of FDI as opposed to other, more liquid forms of capital is relevant, but most likely not the only factor. Part of the explanation may lie in the inherent risk-sharing nature of FDI; a local firm with a foreign partner may be able to withstand financial volatility better than a firm without any external resources. Mihir Desai and C. Fritz Foley of Harvard and Kristin J. Forbes of MIT (working paper here), for example, compared the response of affiliates of U.S. multinationals and local firms in the tradable sectors of emerging market countries to currency depreciations, and found that the affiliates increased their sales, assets and investments more than local firms did.  As a result, they pointed out, multinational affiliations might mitigate some of the effects of currency crises.

The increased vulnerability of countries to financial crises due to debt inflows makes recent developments in the emerging markets worrisome. Michael Chui, Emese Kuruc and Philip Turner of the Bank for International Settlements have pointed to the increase in the debt of emerging market companies, much of which is denominated in foreign currencies. Aggregate currency mismatches are not a cause for concern due to the large foreign exchange holdings of the central banks of many of these countries, but the currency mismatches of the private sector are much larger. Whether or not governments will use their foreign exchange holdings to bail out over-extended private firms is very much an open issue.

Philip Coggan of the Buttonwood column in The Economist has looked at the foreign demand for the burgeoning corporate debt of emerging markets, and warned investors that “Just as they are piling into this asset class, its credit fundamentals are deteriorating.” The relatively weak prospects of these firms are attributed to the slow growth of international trade and the weakening of global value chains. Corporate defaults have risen in recent years, and Coggan warns that “More defaults are probably on the way.”

The IMF’s latest World Economic Outlook forecasts increased growth in the emerging market economies in 2016. But the IMF adds: “However, the outlook for these economies is uneven and generally weaker than in the past.” The increase in debt offerings by firms in emerging market economies will bear negative consequences for the issuing firms and their home governments in those emerging market economies that do not fare as well as others. Coggan in his Buttonwood column also claimed that “When things do go wrong for emerging-market borrowers, it seems to happen faster.” Just how fast we may be about to learn. Market conditions can deteriorate quickly and when they do, no one knows how and when they will stabilize.

The Search for an Effective Macro Policy

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Economic growth in the advanced economies seems stalled. This summer the IMF projected increases in GDP in these economies of 1.8% for both 2016 and 2017. This included growth of 2.2% this year in the U.S. and 2.5% in 2017, 1.6% and 1.4% in the Eurozone in 2016 and 2017 respectively, and 0.3% and 0.1% in Japan. U.S. Treasury Secretary Jack Lew has called on the Group of 20 countries to use all available tools to raise growth, as has the IMF’s Managing Director Christine Lagarde. So why aren’t the G20 governments doing more?

The use of discretionary fiscal policy as a stimulus seems to be jammed, despite renewed interest in its effectiveness by macroeconomists such as Christopher Sims of Princeton University. While the U.S. presidential candidates talk about spending on much-needed infrastructure, there is little chance that a Republican-controlled House of Representatives would go along. In Europe, Germany’s fiscal surplus gives it the ability to increase spending that would benefit its neighbors, but it shows no interest in doing so (see Brad Setser and Paul Krugman). And the IMF does not seem to be following its own policy guidelines in its advice to individual governments.

One of the traditional concerns raised by fiscal deficits rests on their impact on the private spending that will be crowded out by the subsequent rise in interest rates. But this is not a relevant problem in a world of negative interest rates in many advanced economies and very low rates in the U.S. The increase in sovereign debt payments should be more than offset by the increase in economic activity that will be reinforced by the effect of spending on infrastructure on future growth.

On the other hand, there has been no hesitation by monetary policymakers in responding to economic conditions. They initially reacted to the global financial crisis by cutting policy rates and providing liquidity to banks. When the ensuing recovery proved to be weak, they undertook large-scale purchases of assets, known in the U.S. as “quantitative easing,” to bring down long-term rates that are relevant for business loans and mortgages.The asset purchases of the central banks led to massive expansions of their balance sheets on a scale never seen before. The Federal Reserve’s assets, for example, rose from about $900 billion in 2007 to $4.4 trillion this summer. Similarly, the Bank of Japan holds assets worth about $4.5 trillion, while the European Central Bank owns $3.5 trillion of assets.

The interventions of the central banks were successful in bringing down interest rates. They also elevated the prices of financial assets, including stock prices. But their impact on real economic activity seems to be stunted. While the expansion in the U.S. has lowered the unemployment rate to 4.9%, the inflation rate utilized by the Federal Reserve continues to fall below the target 2%. Investment spending is weaker than desired, despite the low interest rates. Indeed, many firms have sufficient cash to finance capital expenditures, but prefer to hold it back. The situations in Europe and Japan are bleaker. Investment in the Eurozone, where the unemployment rate is 10.1%., remains below its pre-crisis peak. Japan also sees weak investment that contributes to its stagnant position.

If lower interest rates do not stimulate domestic demand, there is an alternative channel of transmission: the exchange rate, which can improve the trade balance through expenditure switching. But there are several disturbing aspects of a dependence on a currency depreciation to increase output (see also here). First, there is an adverse impact on domestic firms with liabilities denominated in a foreign currency, as the cost of servicing and repaying that debt rises. Second, expansionary monetary policy does not always have the expected impact on the exchange rate. The Japanese yen appreciated last spring despite the central bank’s acceptance of negative interest rates to spur spending. Third, a successful depreciation requires the willingness of some other nation to accept an appreciation of its currency. The U.S. seems to have accepted that role, but Mohammed A. El-Erian has pointed out, U.S. firms are concerned “…about the impact of a stronger dollar on their earnings…” He also points to “…declining inward tourism and a deteriorating trade balance…” Under these circumstances, the willingness of the U.S. government to continue to accept an appreciating dollar is not guaranteed.

There is one other consequence of advanced economies pushing down their interest rates: increased capital flows to emerging market economies. Foreign investors, who had pulled out of bond markets in these countries for much of the last three years, have now reversed course. The inflows may help out those countries that face adverse economic conditions. But if/when the Federal Reserve resumes raising its policy rate, the attraction of these markets may pall.

The search for an effective macro policy tool, therefore, is constrained by political considerations as much as the paucity of options. But there is another factor: is it possible to return to pre-2008 economic growth rates? Harvard’s Larry Summers points out that those rates were based on an unsustainable housing bubble. He believes that private spending will not return us to full-employment, and urges the Fed to keep interest rates low and the government to engage in debt-financed investments in infrastructure projects. Ken Rogoff (also of Harvard), on the other hand, believes that we are suffering the downside of a debt supercycle. Joseph Stiglitz of Columbia University blames deficient aggregate demand in part on income inequality.

The one common theme that emerges from these different analyses is that there is no “quick fix” that will restore the advanced economies to some economic Eden. Structural and other forces are acting as headwinds to slow growth. But voters are not interested in long-run analyses, and many will turn to those who claim that they have solutions, no matter how potentially disastrous those are.

 

Capital Flows and Financial Activity in Commodity Exporters

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Emerging markets and developing economies have struggled in recent years to regain the growth rates of the last decade before the global financial crisis. The slowdown has been particularly evident in commodity-exporters that face declining prices. The World Bank’s most recent Global Economic Prospects, for example, projects growth for those countries of only 0.4% in 2016. Moreover, the fall in commodity prices is linked to capital flows to those countries and an increase in the fragility of their financial sectors.

In a recent paper in the Journal of International Money and Finance, Joseph P. Byrne of Heriot-Watt University and Norbert Fiess of the World Bank examined the determinants of capital inflows to 64 emerging market economies. Among the drivers of capital flows were real commodity prices: an increase in these prices increased flows to the emerging markets, particularly total equity and bank flows. Real commodity prices also contributed to an increase in the global volatility of capital flows.

Commodity price cycles, therefore, should be associated with capital flow cycles, and declines in both may lead to financial crises. Carmen Reinhart of Harvard’s Kennedy School, Vincent Reinhart of the American Enterprise Institute and Christoph Trebesch of the University of Munich documented such a correspondence of capital flows, commodity prices and sovereign defaults during the period 1815 to 2015 in a paper in the American Economic Review Papers and Proceedings 
(working paper here). They found evidence of an overlap between booms in capital flows and commodity prices, which resulted in a “double bonanza,” and a “double bust” when capital flows and prices declined. They also recorded the incidence of sovereign defaults, and found that four of six global peaks in defaults followed double busts in capital flows and commodity markets. The most recent boom was exceptionally prolonged, beginning in 1999 and lasting until 2011, and was followed by a “double bust.”

Commodity prices can also affect the fragility of domestic financial sectors. Tidiane Kinda, Montfort Mlachila and Rasmané Ouedraogo in an IMF working paper looked at the impact of commodity price shocks on the financial sectors in 71 emerging market and developing economies that are commodity exporters. Falling prices weakened the financial sector as manifested through higher non-performing loans and reduced bank profits, and an increased probability of a banking crisis. The transmission channels included an increase in the amount of debt denominated in foreign currency as well as lower economic growth and less government revenues.

The fragility of the financial sectors of the commodity exporters has been exacerbated by a growth in private credit. The World Bank’s Global Economic Prospects has reported that credit to the nonfinancial sector in emerging markets and developing economies increased in the five years ending in 2015, and credit growth was particularly pronounced in commodity exporting countries. Much of this credit went to nonfinancial corporations, and the borrowing was concentrated in the energy sector. As a result, credit growth in the commodity exporting emerging market and developing economies has risen to levels of credit/GDP that in the past have been associated with credit booms that have often (but not always) been followed by bank crises.

Commodity price fluctuations, therefore, are accompanied by changes in capital flows and the status of financial sectors in commodity exporters. Booms in domestic credit can further threaten long-term financial stability. More flexible exchange rates may alleviate some of the strain of a downturn in commodity prices and capital inflows. But countries such as Brazil, Indonesia and Russia face little relief from the drag on their economic performance as long as commodity prices remain depressed. The accommodative monetary policies of the advanced economies have bolstered asset prices in many emerging markets, but that situation can not be counted on to continue indefinitely.

The Impact of Financial Globalization on the Brexit Vote

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The reasons for the majority vote in favor of the United Kingdom leaving the European Union will be studied and analyzed for years to come. Globalization in the form of migration—or fear of migration—played a considerable role. Support for leaving the EU was also high in the British version of the “rust belt,” in this case the industrial Northern areas that have lost jobs to overseas competitors. But financial globalization also played a role in exacerbating the divisions that led to the vote to exit.

London’s role as an international financial center has served that city well. According to The Guardian, “The capital generates 22% of the UK’s gross domestic product, much of this from financial services, despite accounting for only 12.5% of the UK population.” Those employed in the financial sector have been well compensated for their work. In a study of financial sector wages in London, Joanne Lindley of King’s College London and Steve McIntosh of the University of Sheffield (see a shorter version here) report that “…the average wage in the financial sector was almost three times as large as the average wage across the whole private sector in 2009.” The same phenomenon has been observed in wages in the U.S. financial sector as well as in other European economies.

The relatively high wages paid to those employed in the financial sector contributes to rising income inequality in the UK. The Gini coefficient, a measure of income inequality, has soared in recent years, and according to one report is now the highest in Europe. According to the Equality Trust, “Average household income in London is considerably higher than in the North East.” But this disparity across the regions of the country has not been an issue in recent elections, leaving those outside the financial sector feeling left behind and marginalized.

These developments are consistent with a broader trend towards higher inequality in economies that have deregulated their capital accounts. Davide Furceri and Prakash Loungani of the IMF (see also here) examined the distributional impact of capital account liberalization in 149 countries over the period of 1970 to 2010. They found that capital liberalization reforms increase inequality and reduce the labor share of income. The latter effect is particularly prevalent in high- and middle-income countries.

A UK withdrawal from the EU will entail significant changes in both that country and the EU, which in turn will affect the direction of financial globalization. Financial services exports account for a large proportion of all the UK’s financial services operations. The UK’s membership in the EU has allowed it to provide these services to other EU members. But if the UK leaves the EU, the country will have to negotiate continued access to the EU’s financial markets, and the remaining EU members will most likely be unwilling to permit this if the country is unwilling to adopt EU standards in other areas such as the movements of people.

If financial service providers no longer find the UK to be a suitable location, the effect will be seen in the balance of payments. The country’s current account deficit, which reached 5.2% of GDP last year and 7% in the first quarter of this year, has been financed by capital inflows, including inward FDI. Capital inflows will drop off as international banks and other financial services providers relocate at least some of their operations to EU countries where membership is not an issue. The sharp exchange rate depreciation after the vote may partially reverse the current account deficit, but a decline in capital inflows will exacerbate the situation.

In the meantime, the supervision of financial services within the UK will be muddled as regulators decide which rules to keep and which need to be modified. The loss of the UK as a member will also affect the design of financial regulations within the EU, as the UK has played a major role in promoting a more liberal approach to regulation within the union. If it no longer serves as an advocate for that position, the EU members may adopt a more regulatory approach that favors banks over capital markets.

But many Britons will be unsympathetic to these effects of the referendum. Their vote is one more unfavorable verdict on globalization, similar to those seen in the U.S. and other European countries (see here and here). Until there is confidence that globalization delivers benefits for all of society or that there are mechanisms to share the rewards, the negative backlash will continue. Criticizing the Brexit vote or the measures proposed by Donald Trump is not sufficient: voters need to believe that globalization can be handled in a responsible and evenhanded fashion. Managing the direction and impact of globalization–including capital flows–without reversing its direction may be the biggest task facing the next President of the U.S. and other national leaders.

Conferences

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The end of the academic year is here, and many academic conferences are taking place. The ones that may of interest to readers of this blog include:

May 22-25. International Trade & Finance Association Conference. Occidental College, Los Angeles, CA, U.S.

May 26-28. Annual International Conference on Macroeconomic Analysis and International Finance. University of Crete, Greece.

June 13-14. INFINITI Conference on International Finance. Trinity College, Dublin, Ireland.

June 13-14. Barcelona GSE Summer Forum: International Capital Flows.  Barcelona Graduate School of Economics, Spain.

June 16-19. European Economics and Finance Society Conference. Amsterdam, the Netherlands.

June 17. Annual Conference in International Finance. City University of Hong Kong, Hong Kong.

July 11-15. NBER Summer Institute: International Finance. Cambridge. MA, U.S.

Now, I realize that June is a good month in which to hold a conference. But four in the same week in June?!? Some explicit coordination by the organizers would make attending these events much easier.

 

The Role of the U.S. in the Global Financial System

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The mandate of the Federal Reserve is clear: “…promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” How to achieve those goals, of course, has been the subject of great debate: should the central bank use interest rates or monetary aggregates? should it rely on rules or discretion? The ongoing controversy within the U.S. over the benefits and costs of globalization opens up the issue of the geographic scope of the Fed’s responsibilities: does the Fed (and for that matter the U.S. Treasury) need to worry about the rest of the world?

Stanley Fischer, Federal Reserve Vice Chair (and former first deputy managing director of the IMF) sees a role for limited intervention. Fischer acknowledges the feedback effects between the U.S. and the rest of the world. The U.S. economy represents nearly one quarter of the global economy, and this preponderance means that U.S. developments have global spillovers. Changes in U.S. interest rates, for example, are transmitted to the rest of the world, and the “taper tantrum” showed how severe the responses could be. Therefore, Fischer argues, our first responsibility is “to keep our own house in order.” It also entails acknowledging that efforts to restore financial stability can not be limited by national borders. During the global financial crisis, the Fed established swap lines with foreign central banks so that they could provide liquidity to their own banks that had borrowed in dollars to hold U.S. mortgage-backed securities. Fischer cautions, however, that the Fed’s global responsibilities are not unbounded. He acknowledges Charles Kindleberger’s assertion that international stability can only be ensured by a financial hegemon or global central bank, but Fischer states, “…the U.S. Federal Reserve System is not that bank.”

The U.S. did hold that hegemonic position, however, during the Bretton Woods era when we ensured the convertibility of dollars held by central banks to gold. We abandoned the role when President Richard Nixon ended gold convertibility in 1971 and the Bretton Woods system subsequently ended. Governments have subsequently experimented with all sorts of exchange rate regimes, from fixed to floating and virtually everything in between.

While many countries do not intervene in the currency markets, others do, so there is a case for a reserve currency. But perhaps more importantly, we live in an era of global finance, and much of these financial flows are denominated in dollars. The offshore dollar banking system, which began in the 1960s with the Eurodollar market, now encompasses emerging markets as well as upper-income countries. This financial structure is vulnerable to systemic risk. Patrick Foulis of The Economist believes that “The lesson of 2007-08 was that a run in the offshore dollar archipelago can bring down the entire financial system, including Wall Street, and that the system needs a lender of last resort.”

Are there alternatives to the U.S. as a linchpin? The IMF is the international agency assigned the task of ensuring the provision of the international public good of international economic and financial stability. Its track record during the 2008-09 crisis showed that it could respond quickly and with enough financial firepower to deal with global volatility (see Chapter 10). But it can only move when its principals, the 189 member nations, allow it to do so. The Fund’s subsequent dealings with the European nations in the Greek financial crisis demonstrate that it can be tripped up by politics.

Is China ready to take on the responsibilities of an international financial hegemon? Its economy rivals, if not surpasses, that of the U.S. in size, and it is a dominant international global trader. China’s financial footprint is growing as well, and the central bank has established its own series of swap lines. This past year the renminbi was included in the basket of currencies that are used to value the IMF’s Special Drawing Rights. But the government has moved cautiously in removing capital account regulations in order to avoid massive flows in either direction, so there is limited liquidity. Chinese debt problems do not encourage confidence in its ability to deal with financial stress.

The Federal Reserve is well aware that international linkages work both ways. Fed Chair Janet Yellen cited concerns about the Chinese economy last fall when the Fed held back its first increase in the Federal Funds rate. And Fed Governor Lael Brainard believes that the global role of the dollar and the proximity to a zero lower bound may amplify spillovers from foreign conditions onto the U.S.

Whether or not the U.S. has a special responsibility to promote international financial stability may depend in part on one’s views of the stability of global capital markets. If they are basically stable and only occasionally pushed into episodes of excess volatility, then coordinated national policies may be sufficient to return them to normalcy. But if the structure of the global financial system is inherently shaky, then the U.S. needs to be ready to step in when the next crisis occurs. Andrés Velasco of Columbia University believes that “Recent financial history suggests that the next liquidity crisis is just around the corner, and that such crises can impose enormous economic and social costs. And in a largely dollarized world economy, the only certain tool for avoiding such crises is a lender of last resort in dollars.”

Unfortunately, if a crisis does occur it will take place during a period when the U.S. is reassessing its international ties. Donald Trump, the presumptive Republican candidate, achieved that position in part because of his argument that past U.S. trade and finance deals were against our national interests. He shows little interest in maintaining multilateral arrangements such as the United Nations. Trump has announced that he would most likely replace Janet Yellen because of her political affiliation. It is doubtful that the criteria for a new Chair would include a sensitivity to the international ramifications of U.S. policies.

The interest of the U.S. public in international dealings has always waxed and waned, and Trump’s nomination is a sign that we are in a period when many believe we should minimize our engagement with the rest of the world. But this will be difficult to do as long as the dollar remains the predominant world currency for private as well as official use. Regardless of domestic politics, we will not escape the fallout of another crisis, regardless of where it starts. It would be better to accept our international role and seeks ways to minimize risk than to undertake a futile attempt to make the world go away.

The People’s Verdict on Globalization

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The similarities in the electoral appeals of businessman Donald Trump and Senator Bernie Sanders have been widely noted (see, for example, here, here and here). Both men attract voters who feel trapped in their economic status, unable to make progress either for themselves or their children. Moreover, both men have assigned the blame for the loss of manufacturing jobs in the U.S. on international trade agreements. Regardless of who wins the election, globalization, which was seen as a irresistible force in the 1990s after the collapse of the Soviet Union and the entry of China into the world economy, is now being reexamined and found to be detrimental in the eyes of many.

Trump and Sanders have been particularly vociferous about the North American Trade Agreement, which they hold responsible for the migration of U.S. jobs to Mexico. But those who blame the foreign sector for a loss of jobs should also finger capital flows. The investment of U.S. firms in overseas facilities that then ship their products back to the U.S. represents outward foreign direct investment (FDI), and thus in this story is also responsible for the disappearance of manufacturing jobs. Moreover, Lawrence Summers of Harvard has pointed out that firms that have the option to relocate will be less inclined to invest in new capital in their home country, which leads to lower productivity and wages for their workers.

Whether technology or trade is more responsible for the shrinkage in manufacturing jobs has been the subject of much study (see, for example, here). In the past, most studies assigned the primary role for labor force disruption to technology. David Autor of MIT, Lawrence F. Katz of Harvard and Melissa S. Kearney of the University of Maryland, for example, drew attention to technology that accomplishes routine tasks without human intervention and leads to a polarization of the labor force, as middle-skill level jobs are eliminated, leaving only low-skill and high-skill jobs. In addition, information technology that allows firms to coordinate their facilities in different countries allows more outsourcing and reallocation of plants.

Those who seek to defend global trade flows cite rises in employment due to exports and also gains due to increases in efficiency and economics of scale that accompany specialization. In addition, lower prices due to imports raise real incomes. No one denies that increased imports can disrupt labor markets, but this has viewed as a transitional cost that could be absorbed.

But recent economic studies by widely respected economists (including MIT’s Autor) have found that imports—and in particular, imports from China—are responsible for some of the loss of U.S. manufacturing jobs. Autor, David Dorn at the University of Zurich and Gordon Hanson at the University of California—San Diego view China’s entry into world markets as an epochal shock. Standard economic analysis would have predicted a shift within U.S. industries as workers in firms that lost their markets to Chinese imports migrated to other sectors, with no change in aggregate employment. But in reality the shift to new jobs by those workers exposed to import competition has not taken place and employment has fallen in those labor markets. In another study with MIT’s Daron Acemoglu and Brendan Price, these authors estimate U.S. job losses from Chinese import competition in the range of 2 – 2.4 million.

The relative effects of technology and international trade/finance on employment will undoubtedly be investigated, analyzed and debated for many years to come. But Steven R. Weisman of the Peterson Institute for International Economics makes an important point in his new book on globalization, The Great Tradeoff: Confronting Moral Conflicts in the Era of Globalization:

Facts, by themselves, will never definitely resolve the arguments over the effects of trade and investment on inequality or economic justice in general. Globalization, and indeed the full array of political conflicts in the modern era, must be resolved by men and women, not idealized concepts and truths.

A honest debate over the benefits and costs of globalization is overdue. To date, the U.S. has managed to avoid hard choices, but that will not continue, Dani Rodrik of Harvard’s Kennedy School of Government has examined the policy challenge In his book, The Globalization Paradox: Democracy and the Future of the World Economy. He makes the case for the existence of a policy “trilemma,” by which he means that a nation can not simultaneously have democracy, national sovereignty and “hyperglobalization,” i.e., the removal of all domestic barriers to trade and finance.

Rodrik examines the three possible national positions under his trilemma. If a nation totally embraces the global economy, then it can not allow domestic politics to enact rules and regulations that are not in alignment with international standards. He cites the era of the Gold Standard as a period when nations could not exercise discretionary policies. On the other hand, democratically elected global institutions could devise global regulations for the global markets. This would require a sort of global federalism, i.e., the U.S. model on a wider scale. Rodrik cites the European Union as a possible move in this direction, but was skeptical when he wrote his book of the feasibility of the EU expanding its scope. Recent events have certainly diminished any confidence in that model.

That leaves the “Bretton Woods compromise,” which is the use of national regulations by nations to choose their degree of integration with international markets. The restrictions on capital flows under the Bretton Woods international monetary system allowed governments to use macroeconomic policies to attain full employment (see Ch. 2 here). Similarly, Japan, Korea, China and other East Asian economies implemented measures to promote exports to accelerate growth. The global economy benefitted those who engaged in it, but each nation chose the scale of its involvement.

Rodrik raised a concern that the embrace of the global economy has engendered democratic oversight. In the case of the U.S., this may have been mitigated by the role of the U.S. as a global hegemon that set the pace for hyperglobalization. The U.S. was an active proponent of the World Trade Organization (WTO), which replaced the General Agreement on Tariffs and Trade (GATT) in 1995 and has sought to further trade integration. Financial deregulation began in the U.S. in the 1980s with the removal of regulations on thrifts, and continued in the 1990s with the elimination of restrictions on interstate banking and the repeal of the Glass-Steagall Act that had separated commercial banking from other financial activities such as underwriting.

Both U.S. political parties embraced global economic integration. In the Republican party, the pro-business wing was allied with social conservatives and a group thaty advocated a strong military presence. The Democrats joined together unions with pro-business groups. But this year’s primaries are demonstrating that these coalitions are breaking down. Both Trump and Sanders are giving voice to those who feel that their support has been taken for granted and their concerns and interests ignored. There are projections of fundamental realignments on both sides of the political duopoly (see here and here), which may bring about a change in the U.S. position on globalization.

It is not clear what options are available. Despite the promises of Trump and other politicians, the jobs that have either been outmoded by technology or moved away will not be recreated. But it may be possible to devise stronger safety nets for those who do not share directly in the gains of more international trade and investment. President Obama went a long way in that direction through his achievement of expanded health care coverage. Rodrik believes that upper-income countries “…must address domestic concerns over inequality and distributive justice. This requires placing some sand in the wheels of globalization.” Summers has called for a shift in focus in negotiations from trade agreements to international harmonization agreements, that would include labor rights and environmental protection.

All this should be addressed, and quickly, since China’s impact on the global economy has not yet been fully felt. Arvind Subramanian and Martin Kessler of the Peterson Institute for International Economics claim that China’s effect on global trade makes it a “mega-trader.” A similar phenomenon may take place in the financial markets as China continues its relaxation of capital controls. The IMF has found that growth “surprises” in China already have a significant impact on equity markets in other economies. But the IMF expects that financial spillovers will become more significant in the future, particularly if Chinese residents are allowed to hold foreign equity and bonds. Martin Wolf points out that capital account liberalization may lead to a “large net capital outflow from China, a weaker exchange rate and a bigger current account surplus.” The international financial system is not robust enough to withstand another shock, which would only encourage more calls for nationalist measures. The costs of globalization must be explicitly addressed if we expect the public to ignore the siren song of politicians who would use protectionist measures to protect voters from the consequences of further globalization.