Category Archives: Globalization

The Costs of the Defragmentation of the Global Economy

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The integration of markets across borders has slowed down, and in some cases, reversed. These changes come in the wake of the global financial crisis, Donald Trump’s embrace of trade restrictions, Great Britain’s withdrawal from the European Union, the disruptions in global supply chains during the pandemic, and the invasion of Ukraine. President Biden has shown a willingness to use trade and financial restrictions in response to what he views as Chinese and Russian threats to U.S. strategic interests, and there are responses to the use of sanctions and other tools of disruption. The fallout from this rift will take years to play out.

A team of IMF economists have written a Discussion Note on Geoeconomic Fragmentation and the Future of Multilateralism. They attribute the reversal of economic integration to national considerations, such as the desire of governments to increase their domestic production capabilities in particular areas. But the authors of the Note point out that while fragmentation may achieve some goals, it also imposes costs. These include: “higher import prices, segmented markets, diminished access to technology and to both skilled and unskilled labor, and ultimately reduced productivity which may result in lower living standards.” Moreover, fragmentation will slow down joint efforts to address global issues such as climate change.

The Discussion Note summarizes the results of several studies of the loss from geoeconomic fragmentation. In all the studies they cite, the costs are greater the larger the degree of fragmentation. Among the reasons for the losses in output are reduced knowledge diffusion due to technological decoupling. Not surprisingly, low income and emerging market countries are most at risk from a separation from the latest technological developments.

Pinelopi K. Goldberg of Yale and Tristan Reed of the World Bank Group (Goldberg is former chief economist of the World Bank) examine the prospects for global trade in their recent NBER Working Paper “Is the Global Economy Deglobalizing? And if so, why? And what is next?” They find that “slowbalization” is a better description of the recent trend in international trade than “deglobalization.” Foreign direct investment and migration have exhibited relatively less slowdowns. But the authors also document changes in U.S. policies and public attitudes that represent a marked shift away from the liberalization of trade. They attribute these reversals to various factors, including the impact of imports on U.S. labor, concerns over the resilience of global supply chains, and national security considerations.

Goldberg and Reed conclude their analysis with some projections of the consequences of deglobalization. They point out that the previous regime of the last three decades led to growth and technological progress They warn that global innovation will be particularly slowed by a decoupling of the U.S. and China  Reconfiguring production supply chains will slow growth as well. These reversals and changes raise the possibility that the recent decline in global inequality will halt, with low-income countries most at risk.

Trade, of course, is not the only component of international commerce that has undergone changes in how it is organized. Chapter 4 of the IMF’s most recent World Economic Outlook analyses the geoeconomic fragmentation of FDI. The authors point to an increase in the “reshoring” and “friend-shoring” of production facilities domestically or to countries with similar political alignments. They estimate a model of the impact of geopolitical alignment on FDI flows, and find that geopolitical factors account for part of the shift in bilateral FDI to countries with governments with similar views to the home country. This could presage a shift to more FDI among advanced economies, rather than emerging markets and developing economies that may differ on political issues.

The Fund’s economists also analyzed the output costs of FDI fragmentation. They utilized different scenarios of geopolitical alignment, such as a world divided into a U.S.-centered block and a China-centered block, with India and Indonesia and Latin America and the Caribbean as nonaligned. In this scenario, the impact of smaller capital stocks and less productivity cumulate with long-term output losses of 2%. Other scenarios allow for the diversion of investment flows to some areas that could offset a decline in global economic activity. However, the chapter’s authors also warn that nonaligned nations may face pressures to choose one side over the other. They conclude from their analysis: “…a fragmented global economy is likely to be a poorer one. While there may be relative—and possibly absolute—winners from diversion, such gains are subject to substantial uncertainty.”

Other forms of capital flows are also subject to fragmentation, and the IMF’s economists examine these trends is a chapter of the latest Global Stability Report. In their analysis, geopolitical tensions can lead to instability through two channels. The first is a financial channel that could respond to increased restrictions on capital flows, greater uncertainty or conflict. The second channel is a real channel, due to disruptions in trade and technology transfers or volatile commodity markets. These two channels can reinforce each other. Restrictions in trade, for example, could discourage cross-border investments.

Geopolitical affinities affect cross-border capital allocation, and the evidence reported in the chapter indicates that recent events have reinforced this impact. The empirical analysis based on a gravity model finds that a rise in geopolitical tensions can trigger sizable portfolio and bank outflows, particularly in developing and emerging market economies. Geopolitical fragmentation can also lead to a loss in international risk diversification, thus leaving countries more vulnerable to adverse shocks and a sizable welfare loss.

All these analyses from multilateral institutions warn of the negative economic consequences arising from the decoupling of trade and financial ties. But the most threatening effects may come from the deepening division of the world into different blocs. As the dividing lines become solidified, the chances of discord extending beyond economic interactions increase. All this friction arising when climate warming already poses a clear threat to our existence only intensifies the dangers we will face.

The 2022 Globie: Money and Empire

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Every year we name a book the “Globalization Book of the Year” (aka the “Globie”). The prize is (alas!) strictly honorific and does not come with a monetary award. But announcing the award gives me a chance to draw attention to a recent book—or books—that are particularly insightful about globalization. Previous winners are listed at the bottom of the column (also see here and here).

This year’s recipient is Money and Empire: Charles P. Kindleberger and the Dollar System by Perry Mehrling, Professor of International Political Economy at the Pardee School of Global Studies of Boston University. The book is an intellectual biography of Charles Kindleberger, who came to MIT in 1948 after having served at the U.S. Treasury, the Federal Reserve Board, the Bank of International Settlements and the U.S. Department of State. He was the author of a number of articles and books on international macroeconomics and economic history that have retained their relevance long after their initial publication date. In his work he often focused on the policies needed to achieve international stability in a world of different national currencies and policies. He had a insightful perspective on the circumstances that led to the Great Depression, and what needed to be done to avoid a repeat of that catastrophic occurrence.

Among the topics that Mehrling covers is the evolution of Kindleberger’s views on the global economic role of the dollar. The dollar became the international reserve currency under the Bretton Woods regime, which was designed to avoid a repeat of the relative chaos of the 1930s. Foreign central banks held dollars to stabilize the value of their currencies, while the U.S. stood ready to exchange these dollars for gold. What had been a dollar shortage in the period after World War II became a dollar glut in the 1950s and 1960s, however, and the stability of the link to gold was questioned by Robert Triffin and others.

Kindleberger, on the other hand, believed that the dollar was serving an important international function as a key currency, as the pound had done in the pre-WWI ear. The responsibility of the U.S. was to set monetary policies that took account of the state of the world economy. In 1966, he joined with Walter Salant and Emile Despres in writing an article for The Economist, “The Dollar and World Liquidity: A Minority View,”  which advanced the view that the U.S. served as the “world’s banker,” i.e., as a financial intermediary with respect to Europe that issued short-term deposits and invested long-term capital around the world. The result was an unplanned but functional international monetary system. In that perspective, gold was an unnecessary distraction.

The debate over the architecture of the international monetary system seemed to end when Richard Nixon terminated the exchange of gold for dollars in 1971. The U.S. and the European nations also began the transition away from fixed exchange rate regimes, although the Europeans would move to their own “fixed currency” with the euro. But the dollar did not recede into the mix of the international monies. The end of Bretton Woods also meant the end of the acceptance of capital controls, and capital began to flow more freely, first among the advanced economies and then to the emerging market nations. Private capital flows rose in importance in financing corporate and government debt, and in the cases of external finance these debt instruments (particularly of emerging market economies) were denominated in dollars.

By the 2000s the existence of a “global financial cycle”, based on U.S. monetary policy, became widely accepted. The dollar was indeed the international currency, although this was decided by private markets as much as governmental decrees. Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey  of the London Business School, in explaining the central role of the U.S., updated the 1966 title given to the dollar by Kindleberger and his associates to the world’s “venture capitalist.”

One of Kindleberger’s most well known contributions came from his analysis of the Great Depression. Previous work usually placed the blame on the outbreak and/or duration of the crisis to misguided national policies. Kindleberger realized that there was an international dimension: the lack of a country that acted as a leader in providing the international public goods needed for stability. These included maintaining an open market for distress goods, providing long-term lending and overseeing a stable system of exchange rates, ensuring the coordination of macro policies among nations and acting as a lender of last resort. In the 1930s Britain was no longer able to act as the global leader, while the U.S. was not willing to accept that roel. Kindleberger’s insight became the basis of a body of work known as “hegemonic stability,” one of the tenets of international political economy.

Kindleberger offered yet another perspective on financial instability in his Manias, Panics and Crashes. As the title implies, the book is an account of financial crises dating back over time and their common elements. The book was first published in 1978. Robert Aliber took over the job of updating the book after Kindleberger’s death, and the latest edition (the eighth) has Robert N. McCauley as the newest co-author.

 In the book Kindleberger extended Hyman Minsky’s model of financial instability, which was a domestic model, to include an international dimension. Minsky had proposed that credit expansion and contraction followed a cycle of initial displacement, boom, euphoria, profit taking, and panic. In a global context, this cycle can be amplified by short-term international capital flows, that increase the amount of credit that is available during the early stages of the cycle. But the money is rapidly withdrawn by foreign investors when doubts arise about the solvency of the projects they have financed. The withdrawal of foreign capital exacerbates the instability of the last stages of the cycle. Kindleberger’s adaptation of Minsky’s work proved to be remarkably prescient during the emerging market economies’ crises of the 1990s, such as the Asian crisis, as well as the global financial crisis.

Mehrling, therefore, has done a valuable service in explaining Kindleberger’s contributions to our understanding of the global economy. Because his analyses were not based on mathematical models or econometric testing, Kindleberger did not receive the same degree of respect as did his colleagues at MIT and elsewhere who used these tools. But the passing of time demonstrates that Kindleberger possessed a keen understanding of how capital and credit flows functioned, and the need for some form of governmental oversight. Any lack of attention to this work at the time when Kindleberger was active tells us more about the blindfolds of economics than it does about Charles Kindlberger.

“Globies”

2016    Branko Milanovic        Global Inequality

2017    Stephen D. King          Grave New World: The End of Globalization, The Return of History

2018    Adam Tooze                Crashed: How a Decade of Financial Crises Changed the World

2019    Branko Milanovic        Capitalism, Alone

2020    Tim Lee, Jamie Lee      The Rise of Carry

             and Kevin Coldiron

2021    Anthony Elson             The Global Currency Power of the Dollar

             Jeff Garten                  Three Days at Camp David

The Struggle for Hegemony

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The restrictions by the Biden administration on the sale of semiconductor chips and the equipment to manufacture them represent a new stage in the division between China and the U.S. The belief that increased trade would lead to a convergence of Chinese and U.S. interests faded years ago. The history of globalization shows clearly that the chances of Chinese as well as Russian acceptance of a liberal order overseen by the U.S. were unlikely, and a struggle for control inevitable.

The study of hegemonic power can be used to illustrate how discord can arise over the distribution of the global benefits of economic growth. MIT economic historian Charles Kindleberger made the case in The World in Depression, 1929-1939 that international economic prosperity needs a nation to provide leadership. The duties of the hegemonic power include maintaining an open market for imports from countries in distress, providing long-term capital and acting as a lender of last resort. More generally, the hegemonic country provides the public good of rules that govern international transactions and ensures compliance to them by other nations.

Great Britain was the hegemonic power of the 19th century and its dominance lasted until the first World War. This was a period of rapid growth for the European countries and Britain’s “offshoots,” i.e., Canada, the U.S., Australia and New Zealand. The shared economic prosperity made the outbreak of a war among the industrial powers seem unlikely. Norman Angell made the case in The Great Illusion, first published in 1909, that the costs of a war among the industrial powers were so great that they would deter their governments from engaging in conflict.

But the predominance of Britain during this period was being questioned by the U.S. and Germany.  Each country had leaders—President Theodore Roosevelt in the U.S. and Kaiser Wilhelm II in Germany—who made clear that they would not accept subordinate positions. The Germans were particularly resentful of their inability to match the size of Britain’s colonial empire, as the colonies had largely been claimed before Germany’s emergence as a nation in 1871after its defeat of France in the Franco-Prussian War.

Graham Allison of Harvard’s Kennedy School wrote about these tensions, and the British response, in his Destined for War: Can America and China Escape Thucydides’s Trap? The “trap” that Allison draws from the work of the Greek historian Thucydides is the confrontation that arise when a rising power threatens a ruling one. Thucydides wrote about the Peloponnesian War between Athens and Sparta, which occurred when Sparta responded to what it saw as a threat to its dominance of the Greek states by the growing Athenian empire.

In the 19th century, Britain was the dominant power facing challenges from other nations. British statesmen decided that Germany posed a more immediate security threat, and accommodated U.S. demands in the Western Hemisphere without surrendering their own interests. But Britain also built up its already powerful battle fleet and created an alignment with France and Russia, the Triple Entente, to counter a German threat.

This deterrence was not enough to avoid the breakout of World War I. The costs of the war hindered Britain’s ability to resume its hegemonic role, and the U.S. was not willing to take its place. As a result, Kindlerberger claimed, the economic crisis of the 1930s was deeper and more extended than it would have been if an international hegemon had been present. The response of the U.S. in creating the United Nations, the International Monetary Fund, and other multilateral organizations after World War II showed that by that time it had learned the lesson of the need for international institutions.

Allison presents other examples of challenges to hegemonic powers by rising powers. In the 17th century, the Dutch Republic was the leading maritime power. It possessed trading posts and colonies in Asia, Africa, and the Americas, and a formidable fleet of warships to defend them. England resented this control and engaged in three maritime wars with the Dutch. The hostilities between the two countries only ended when William of Orange became King William III of England, and the Dutch and English waged war together on the predominant European land power, France.

Allison makes clear that the rivalry between China and the U.S. need not result in war. Besides the British accommodation of U.S. interests in the late 19th century, he points to the “Cold War” between the Soviet Union and the U.S. as an example of a struggle that did not lead to direct conflict. One of the reasons for the avoidance of the escalation of hostilities to total war was the existence of nuclear weapons,, which dramatically raised the cost of using the full range of weapons. But the Cuban missile crisis showed that it was possible to come perilously close to moving into a full-blown conflict. The expansion of trade and finance to new markets creates opportunities for rivalries and competition that can trigger responses that lead to unforeseen consequences.

Making Friends in the New Global Order

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U.S. Treasury Secretary Janet Yellen gave a talk at the Atlantic Council last April on the future role of cooperation in the global economy. In October Chrystia Freeland, Deputy Prime Minister of Canada and its Minister of Finance, gave an address at the Brookings Institution that presented a similar perspective on how the global economy must be reorganized to meet security demands. Their speeches raise questions about how the new arrangements would operate, and how the rest of the world would fit into the proposed framework.

Yellen declared that the war between Russia and Ukraine had “redrawn the contours of the world economic outlook…” The sanctions imposed by the U.S., the other members of the Group of 7 and the European Union were in response to Russia’s “…having flaunted the rules, norms, and values that underpin the international economy.” She also drew attention to China’s ties with Russia and declared that “The world’s attitude towards China and its willingness to embrace further economic integration may well be affected by China’s reaction to our call for resolute action on Russia.”

Looking forward, she enunciated several propositions to govern future action. The first of these dealt with the need to modernize the existing multilateral approach. Yellen proposed basing economic integration by confining the “friend-shoring” of supply chains to “a large number of trusted countries…” This orientation would lower our vulnerability to countries using their economic resources to “disrupt our economy or exercise unwanted geopolitical leverage.” Left unsaid were the issues of which countries merited trust, and how to deal with those that do not fulfill that criterion.

Freeland spelt out some of the details in her address. She spoke of “a brutal end to a three-decade-long era in geopolitics,” and proposed a new orientation based on three pillars. The first is a strengthening of the connections among democracies, and Freeland specifically cites Yellen’s “friend-shoring” as one way to accomplish this.

The second pillar deals with “in-between countries” in Asia, Africa, the Middle East and Latin America. Freeland insisted that friend-shoring should be open to any countries that “…share our values and is willing to play by collectively agreed upon rules.” She made the claim that a rules-based order will be valuable to smaller countries “…most susceptible to coercion by larger and more hostile economies.”

Finally, with respect to authoritarian governments, Freeland advocated a sharp break with the assumptions of the 33 years. These states have little respect for a rules-based disorder, she claimed, and are hostile to the democracies. The democracies can continue to trade with the authoritarian states but should avoid strategic vulnerabilities in their supply chains.

Yellen and Freeland, therefore, agree that the economic relationships of democratic nations should be based on common values and goals. This is a major pivot from the guiding principles of the last three decades that more trade and investment would lead to shared prosperity, the development of democratic political systems and a diminution of conflict. It is also much more of a “top-down” approach, with governments overseeing the relationships of domestic firms with the rest of the world and evaluating the entry of foreign firms into domestic markets.

These ambitious proposals have met a variety of reactions. Branko Milanovic has called the trading links “trade blocs,” similar to those in the past such as the United Kingdom’s imperial preferences, and “mercantilism under a new name.” But mercantilism was a characteristic of President Trump’s trade policies, as he saw trade as a zero-sum relationship with trade deficits as a loss for the country that sustained them. The new proposals seek security and freedom from the weaponization of trade.

How will other countries, particularly those in Freeland’s second group, respond to these initiatives? The new lineup of countries bears many similarities to the post-World War II division among the “first world” of advanced economies, the “second world” of the Communist bloc that included the Soviet Union and China and the “third world” that was the category of every other country, which included nations with colonial pasts in Asia, Africa and Latin America. Many of the third-world countries sought to establish their independence from the first and second worlds.

Today there are a wide variety of economic and political systems outside the advanced economies. Many would undoubtedly desire to continue exporting to the U.S., the European Union, Japan and Australasia. But do they qualify for Freeland’s friend shoring club?

Vietnam has taken the place of China for many multinationals as a source of low-wage production, and its trade with the U.S. and other countries has propelled its growth. Its government, on the other hand, is a one-party system led by the Communist Party, and Freedom House ranks it as “Not Free.” Bangladesh is another country where growth has been driven by exports, mainly in garments. The Awami League keeps a firm hold on political power and the country is characterized by Freedom House as “partly free.”

The transition to “green energy technologies,” will require the use of cobalt, and the Democratic Republic of Congo supplies more than 63% of the world’s use of the element, as well as other natural resources. But the inhabitants of that country do not benefit from their extraction and export, and their political system has been volatile at best. Freedom House rates it as “not free.”

Many other countries that engage in transactions with the advanced democracies will not qualify for membership in the friend-shoring club as defined by Freeland. Moreover, they may not want to choose ideological sides between the two sides in the new order. How will Yellen and Freeland’s democracies deal with these countries? Will they be excluded from trade and financial flows? Or will economic relationships with them be allowed to avoid dependence on the authoritarian countries that are viewed as threats to the security of the democracies? The diversity of economic and political systems in the emerging markets and developing countries will resist easy categorization and pose challenges to Yellen’s and Freeland’s configuration of the world’s economies.

Has the Third Era of Globalization Ended?

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Behind the headlines forecasting a global economic recession there is another narrative about the end of globalization. This reflects political tensions over trade, the impact of the pandemic on global supply chains and the shutdown of economic ties with Russia. But dating the beginning and end of the most recent era of the integration of global markets poses challenges.

All chronological assignments for the purpose of establishing historical eras are arbitrary. Did World War II begin in 1939 when Germany and the Soviet Union invaded Poland? Or in 1937 when Japan invaded China? When was the First Industrial Revolution succeeded by the Second Revolution? Mid or late 19th century? And good luck finding agreement on when the golden age of rock and roll took place.

The dating of economic eras also involves assumptions. Did the First Era of Globalization begin in the early 1870s as usually stated, and if so, why? Germany’s adoption of the gold standard at that time is usually seen as a shift in monetary regimes that facilitated international capital flows, but trade and migration flows had expanded prior to the 1870s. Assigning a date to the end of the First Era is easier to do, as currency convertibility was suspended during World War I and borders were shut to migration.

The commencement of the Bretton Woods (BW) system marks the beginning of the Second Era of Globalization. The agreement was signed in 1944 and the IMF commenced operations in 1947, so 1945 can be seen as the beginning of the post-war era. But the system actually described in the agreement did not operate until 1958 when European currencies became fully convertible for current account transactions. Did the BW regime end in 1971, when President Richard Nixon ended the convertibility of foreign central bank holdings of dollars to gold? Or in 1973, when attempts to establish new fixed exchange rate values ended and the major currencies began to float? The IMF’s Articles of Agreement were not amended to reflect the new practices until 1976.

The Bretton Woods system ended in the 1970s, but globalization did not go into reverse. The post-World War II era can be extended to include the following decades, but that would overlook several important changes in how international economic affairs were conducted. The elections of Margaret Thatcher and Ronald Reagan in 1980 are widely seen as marking the beginning of what has been called the neoliberal era, which has been characterized as a shift to dependence on market outcomes. (Gary Gerstle of Cambridge University, however, shows that the term “neoliberal” encompasses a number of political agendas, not all of them consistent, in a compelling account in his book The Rise and Fall of the Neoliberal Order: America and the World in the Free Market Era.) The initial policy changes occurred domestically, but this was also the period when the IMF began to promote the removal of capital controls. On the other hand, the 1980s was a “lost decade” of growth for those countries, mainly in Latin America, that were embroiled in the debt crisis.

The year 1990 is another candidate for dating the start of a new era of globalization. Douglas Irwin of Dartmouth College has described the era of 1985-1995 as the period of “the greatest reduction in global trade barriers in world history.” China began to allow private enterprises to flourish at the end of the 1980s, while East European nations sought to integrate their economies with those of Western Europe and the rest of the global economy after the collapse of the Soviet Union in 1991. The North American Free Trade Agreement (NAFTA) signed in 1994 by Canada, Mexico, and the U. S. created a trilateral trade area amongst the three countries.  In 1995, the World Trade Organization was established, with a mission to facilitate international trade. The new international agency sought to promote new trade agreements while administering a mechanism to resolve trade disputes amongst its members. Economic inequality among nations narrowed during this period as many emerging markets enjoyed rapid growth, although inequality within nations rose as the benefits of global trade and financial flows were not equally shared.

But if the Third Era of Globalization is no longer operating, when did it cease? The global financial collapse of 2008-09 demonstrated the fragility of extended financial sectors even in the advanced economies, and lacerated confidence in the ability of regulators to anticipate sudden collapses of financial flows. The response of domestic governments and international agencies to the crisis led to a revival of economic activity but the recovery was slow, particularly for those who did not benefit from the rise in asset prices that low interest rates fostered. Foreign expansion by multinational firms continued but the pace of foreign direct investment slackened, while the IMF issued a reappraisal of its policy recommendations regarding capital flows to include capital controls as an acceptable macro policy tool.

The year 2016 has a strong claim for marking the end of this era of globalization. Donald Trump campaigned advocating the use of tariffs to end trade deficits and the erection of a wall along the border with Mexico to halt illegal immigration. He sought to implement those policies after his election, including the imposition of tariffs on Chinese goods. The votes in favor of Britain leaving the European Union (“Brexit”) in the same year demonstrated the distrust of many British citizens of multilateral governance as well as a fear of immigration. The result in that country has been a reduction in trade and migrant flows, with no evidence of a positive economic payoff.

Whatever momentum was left in international economic expansion was throttled by the pandemic and then the Russian-Ukraine war. The pandemic exposed the vulnerability of global supply chains to national shutdowns, and the dangers of dependence on single suppliers of strategic goods, such as medical equipment. In response to the invasion of Ukraine, the U.S. and European allies have sought to cut off trade and financial flows with Russia, which in turn seeks to use higher oil and gas prices to lower Western morale. The U.S. hopes to slow down Chinese technological advances by scrutinizing Chinese acquisition of U.S. firms while supporting U.S. firms in areas where they may fallen behind.

Whether or not the third era of globalization expired in 2016, 2020 or 2022, there is a strong sense that a new era has begun. But is it the end of globalization? Richard Baldwin of the Geneva Institute in his NBER paper, “Globotics and Macroeconomics: Globalisation and Automation of the Service Sector” and in a series of blog posts argues that changes in global economic activity have been misunderstood and misinterpreted. The drop of world trade/GDP since 2008 was largely a function of the decline in the value of commodities, particularly mining goods and fuels.

There has also been a slowdown in the transfer of manufacturing from advanced economies to a handful of emerging economies, as well as a reorganization of supply chains. But Baldwin shows that a new wave of globalization is taking place in the provision of intermediate service activities, which include accounting, financial analysis, legal analysis, and other activities. Advanced economies still account for the majority of service exports but emerging economies including China, India, Korea, Poland, the Philippines and Brazil have recorded rapid growth in these activities. The barriers to further expansion are technological, not regulatory, and those barriers are falling rapidly.

It is premature, therefore, to proclaim the end of globalization. Trade in manufactured goods may not be advancing at the same pace as it has in the past but that slowdown was inevitable. Trade in services, on the other hand, has grown continuously since 1990, although some deceleration in the current economic environment is inevitable. However, advances in artificial intelligence (AI) will alter the supply of both goods and services. Its impact on national economies and global markets is a matter of speculation, but the widespread use of AI may herald the start of the next era of glovalization.

The Need for a Global Corporate Tax Regime

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When the Organization for Economic Cooperation and Development began its call for a reform of the rules of global taxes in order to clamp down on the avoidance of taxes by multinational corporations, its efforts looked quixotic. But the OECD persisted, and U.S. Treasury Secretary Janet Yellen is now participating in negotiations with the other OECD members to reform the (non-)system. While there is much left to negotiate, the broad framework of an agreement to establish a new regime, which governs where taxes are assessed and the determination of a global minimum tax, now exists.

A new volume edited by IMF economists Ruud A. de Mooij, Alexander D. Klemm and Victoria J. Perry, Corporate Income Taxes under Pressure : Why Reform Is Needed and How It Could Be Designed, presents the case for implementing a global approach. The first part of the volume describes the reasons for taxing corporate profits, explains the emergence of the rules governing how multinationals could be treated, and shows the complications that the growth in services and digital trade placed on an already fragile system. The second section examines the workings of the current system, including the difference between source-based and residence-based taxes, the use of bilateral tax treaties to allocate taxing rights, and the ability of corporations to use the differences amongst tax regimes to lower their liabilities by shifting the source of their profits to low-tax jurisdictions. The third section analyzes the relative merits of various reform proposals.

The magnitude of lost tax revenues can only be estimated, since multinationals are not required to report all the data on their operations. But economists have used the available data in inventive ways to estimate the losses.  Kimberly Clausing of Reed College explains the data limitations and the attempts to provide reasonable estimates with the data that are available in a recent paper,  “How Big is Profit Shifting?”. Most of the profit shifting undertaken by U.S.-based multinationals occurs with a few tax havens: Bermuda, Cayman Islands, Ireland, Luxembourg, Netherlands. Singapore, and Switzerland. Clausing calculates that U.S. tax revenue losses from such activities may gave reached $100 billion in 2017, about a third of federal corporate tax revenues.

The OECD has made available a great deal of documentation on the challenges of profit shifting and the proposals to arrest these activities. Many of these analyses are summarized in Addressing the Tax Challenges from the Digitalisation of the Economy: Highlights. The first part of the document explains the proposals under negotiation, known as Pillar One and Pillar Two. Pillar One expands the right to tax a firm beyond its physical presence in a jurisdiction to include “…a significant and sustained participation of a business in the economy of the jurisdiction, either physically or remotely.” Pillar Two ensures a minimum level of tax on the profits of multinationals.

The OECD estimates that if both proposals were implemented, there would be revenue gains for low, middle and high income jurisdictions. The impact of “investment hubs” is more ambiguous, but they would lose some of their tax base. But could these changes adversely affect business activity? The OECD acknowledges that investment costs would rise, but estimates that the impact on investment would be minor.

Tibor Hanappi amd Ana Cinta González Cabral of the OECD Centre for Tax Policy and Administration present a detailed examination of the effect on investment costs in their paper, “The Impact of the Pillar One and Pillar Two Proposals on MNE’s Investment Costs: An Analysis Using Forward-Looking Effective Tax Rates.” They estimate that the rise in the effective average tax rates (EATR) of multinationals in their sample of 70 jurisdictions would be 0.4 of a percentage point, which is small compared to the existing weighted average 24% EATR. Moreover, the reduction in tax differentials would make other factors, such as education and infrastructure in host countries, more important in determining the location and scale of investments.

An agreement on multinational taxes would benefit the Biden administration, which needs revenue to pay for its ambitious infrastructure plans. The administration could use the implementation of a global tax to counter claims that an increase in the U.S. corporate income tax rate, which fell from 35% to 21% in the Trump administration, would make U.S. firms uncompetitive. A coordinated system of taxes would also be a response to the challenge to the ability of governments to tax businesses that profit shifting has posed. Only a global system would stop the “race to the bottom” of national corporate taxes that has resulted in the current tax regime.

International Factor Payments and the Pandemic

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I have written a piece on international factor payments (migrants’ remittances, FDI income) and the pandemic for Econbrowser, the widely followed blog of Menzie Chinn of the University of Wisconsin and James Hamilton of the University of California-San Diego.

You can find it here:

http://econbrowser.com/archives/2020/07/guest-contribution-international-factor-payments-and-the-pandemic

The 2019 Globie: “Capitalism, Alone” by Branko Milanovic

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The time to announce the recipient of this year’s “Globie” is finally here. Each year I choose a book as the Globalization Book of the Year. The prize is—alas—strictly honorific and does not come with a monetary reward. But it gives me a chance to draw attention to a book that is particularly insightful about some aspect of globalization.  Previous winners are listed at the bottom.

This year’s winner is Branko Milanovic’s Capitalism, Alone: The Future of the System That Rules the World. (This is the second Globie for Milanovic, who won it in 2016 for Global Inequality.) The book is based on the premise that capitalism has become the universal form of economic organization. This type of system is characterized by “production organized for profit using legally free wage labor and mostly privately owned capital, with decentralized coordination.” However, there exist two different types of capitalism: the liberal meritocratic form that developed in the West, and state-led political capitalism, which exists primarily in Asia but also parts of Europe and Africa.

The two models are competitors, in part because of their adoption in different parts of the world and also because they arose in different circumstances. The liberal meritocratic system arose from the class capitalism of the late 19th century, which in turn evolved out of feudalism. Communism, Milanovic writes, took the place of bourgeoise development. Communist parties in countries such as China and Vietnam overthrew the domestic landlord class as well as foreign domination. These countries now seek to re-establish their place in the global distribution of economic power.

Milanovic highlights one characteristic that the two forms of capitalism share: inequality. Inequality in today’s liberal meritocratic capitalism differs from that of classical capitalism in several features. Capital-rich individuals are also labor-rich, which reinforces the inequality. Assortative mating leads to more marriages within income classes. The upper classes use their money to control the political process to maintain their position of privilege.

Because of limited data on income distribution in many of the countries with political capitalism, Milanovic focuses on inequality in China. He attributes its rise to the gap between growth in the urban areas versus the rural, as well the difference in growth between the maritime provinces and those in the western portion of the country. There is also a rising share of income from capital , as well as a high concentration of capital income. In addition, corruption has become systemic, as it was before the communist revolution.

The mobility of labor and capital allows capitalism to operate on a global basis. Migrants from developing economies benefit when they move to advanced economies. But residents in those countries often fear migration because of its potentially disruptive effect on cultural norms, despite the positive spillover effects on the domestic economy. Milanovic proposes granting migrants limited rights, such as a finite term of stay, in order to facilitate their acceptance. He points out, however, the potential downside of the creation of an underclass.

Multinational firms have organized global supply chains that give the parent units in their home countries the ability to coordinate production in different subsidiary units and their suppliers in their host nations. Consequently, the governments of home countries seek to limit the transfer of technology to the periphery nations to avoid losing innovation rents. The host countries, on the other hand, hope to use technology to jump ahead in the development process.

The Trump administration clearly shares these concerns about the impact of globalization. President Trump has urged multinational firms to relocate production facilities within the U.S. Government officials are planning to limit the export of certain technologies while carefully scrutinizing foreign acquisitions of domestic firms in tech-related areas. New restrictions on legal immigration have been enacted that would give priority to a merit-based system. Moreover, the concerns over migration are not unique to the U.S.

Milanovic ends with some provocative thoughts about the future of capitalism. One path would be to a “people’s capitalism,” in which everyone has an approximately equal share of both capital and labor income. This would require tax advantages for the middle class combined with increased taxes on the rich, improvements in the quality of public education, and public funding of political campaigns. But it is also feasible that there will be a move of liberal capitalism toward a form of political capitalism based on the rise of the new elite, who wish to retain their position within society.

Milanovic’s book offers a wide-ranging review of many of the features of contemporary capitalism. He is particularly insightful about the role of corruption in both liberal and political capitalism. Whether or not it is feasible to reform capitalism in order to serve a wider range of interests is one of the most important issues of our time.

2018    Adam Tooze,  Crashed: How a Decade of Financial Crises Changed the World

2017    Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic, Global Inequality

2015    Benjamin J. Cohen. Currency Power: Understanding Monetary Rivalry

2014    Martin Wolf, The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis

The Parting of Ways: The U.S. and China

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The agreement of U.S. President Donald Trump and Chinese President Xi Jingping to restart trade talks put offs planned increases of tariffs on Chinese exports. But there is little doubt that the U.S. intends to move ahead with its intention to undo the economic integration that has been underway since the 1990s. Even when it proves impossible to reverse history, the consequences of such a move will have long-lasting consequences for the global economy.

To understand what is at stake, think of the following simple guide to the status of the world’s nations in the aftermath of World War II. Countries separated into three groups, each anchored on its own tectonic plate. The “first world” consisted of the advanced economies of the U.S., Canada, the West European nations, Japan, Australia and New Zealand. These economies enjoyed rapid growth in the 1950s and 1960s, due in part to the expansion of trade amongst them. The formation of the European Community (now Union) eventually led to a single market in goods and services, capital and labor for its members. The largest of the advanced economies exerted their control through the “Group of Seven,” i.e., Canada, France, Germany, Italy, Japan, the United Kingdom and the U.S. Their leaders met periodically to discuss economic and other types of policies and issued communiques that listed their agreements. Their predominance extended to their control of the International Monetary Fund and the World Bank.

The “second world” included the Communist nations: the Soviet Union and the countries it controlled in Eastern Europe, as well as China and North Korea. These were command economies, run by government ministers. There was some commerce between the Soviet Union and its East European satellites, but all trade was managed. There were virtually no commercial or financial interactions with the first world.

Finally, there was the “third world,” consisting of the remaining nations located in Latin America, Africa, the Middle East and South and East Asia. These countries, also known as the developing economies, encompassed a wide range of economic and political models. Many of them formed an association of “nonaligned” countries that sought to preserve their political independence from the first and second worlds.

The third world had limited trade with the first world nations, and this usually consisted of commodity exports in exchange for imports of industrial goods. Import substitution, i.e., the domestic production of manufactured goods, was proposed in the 1950s as a means to counteract the disadvantageous terms of trade these nations faced for their goods. There was some migration between the first and third worlds, and there was a shift in the home countries of U.S. immigrants from Europe to Latin American and Asia. But the movements of people never approached the magnitudes of the first wave of globalization of 1870-1914.

This account is simplistic, and there are important exceptions. Yugoslavia, for example, escaped the control of the Soviet Union and had its own form of a command economy. Taiwan and South Korea began implementing export-led development policies in the 1970s. There were important differences between the capitalist economies of the U.S. and the Scandinavian nations. But the relative separation of the three “worlds” did limit their interaction, as did the political tensions between the U.S. and its allies on the one hand and the Communist governments on the other.

The partition, however, began to dissolve at the end of the 1980s as the economic tectonic plates underneath these clusters of countries began to split and move. China sought to grow its economy through the use of markets and private firms. The government promoted foreign trade, and allowed investments by foreign firms that could provide capital, technology and managerial expertise.

The dissolution of the Soviet bloc of nations was followed by the integration of the eastern European nations with the rest of Europe. Poland, Hungary, the Czech Republic and other countries provided workforces for foreign–particularly German–firms and their economies grew rapidly. The European Union expanded to include these new members, Russia itself was less successful in adapting its economy to the new configuration, and remained dependent on its oil and natural gas resources.

While the nations of the second world were moving towards those of the first world, the countries in the third world also sought to become part of the global economy. Asian nations, such as India, Indonesia, Thailand and Malaysia, adopted pro-market policies in order to accelerate development. Their expanded trade brought these countries closer to the first world. Global poverty fell, principally due to a fall in the proportion of the poor in the populations of China and India.

But there were serious disruptions to these advances, particularly in those emerging market economies that suffered financial crises: Mexico in 1995, several of the East Asian countries in 1997, Russia in 1998, and Argentina and Turkey in 2001. While some of the crises were the result of unsustainable government policies, there were also outflows of private capital that had fueled credit bubbles. The massive disruption of economic activity in the wake of these “sudden stops” necessitated outside assistance for the countries to recover. The reputation of the IMF suffered a serious blow for its slow response to the Asian crisis, and the Fund subsequently acknowledged that it had underestimated the extent and consequences of their financial fragility.

Moreover, there was collateral damage accompanying the melding of the economic tectonic plates. China’s emergence as a mega-trader had an impact on the production of manufactured goods in the U.S. and other nations. The resulting job losses, that were often conflated with those lost due to technology, turned parts of the populations of the advanced economies against globalization. Migrants were also blamed for the loss of jobs, as were global supply chains by multinational firms.

The global financial crisis of 2007-09 and the ensuing weak recovery increased the questioning of the policies of the previous two decades. Unemployment in the U.S. fell slowly, and debt crises in several European nations kept growth rates depressed. There was an acknowledgement that the benefits of globalization had not been shared equally as public awareness of income and wealth inequality increased.

There was also adverse reactions to political integration. European governments bristled against EU restrictions on their budgetary policies, while In the United Kingdom nationalists argued that EU officials in Brussels had usurped their government’s sovereignty. The waves of refugees who fled to Europe from Syria and elsewhere awakened fears of a loss of national identity.

The election of Donald Trump and the vote in the United Kingdom in favor of leaving the EU made clear the depth of the reaction against the global integration of 1990-2006. Trump’s campaign was based on a pledge to return to some past era when America had been “great,” while proponents of Brexit promised that their country would prosper outside the boundaries of the EU. The bases of support for these policies were not always wide, but they were strongly motivated.

At the same time, the Chinese government has been keen to assert its control of the country’s economic future and to resist outside interference. The Chinese also seek to establish a zone of political domination in Asia. Similarly, Russia’s President Putin has sought to set up a sphere of political and military influence around its borders. Neither government wants to cut their ties with the U.S. and other advanced economies, but they do want to maintain control over their respective geographic areas.

The China-U.S. split, therefore, is part of a larger reaction to the integration of the global economy. The removal of the barriers separating the three post-World War II “worlds” has led to anxiety and fear in those countries that were part of the first world. They look for a return to the economic dominance that they once enjoyed.

But it is not feasible to undo all the ties that have developed over recent decades, and the nations of what had been the second and third worlds will never accept subordinate status. Moreover, it is possible for the U.S. to place barriers on trade and finance that will undo the gains of the last two decades without any offsetting benefits. Even more worrisome is the possibility that economic and political divisions will exacerbate military division and result in conflict.

The earth has several geographic plates, and they move at a rate of one to two inches (three to five centimeters) per year. Over very long periods of time, the plates do collide, and the force of their movements as they smash into each other creates mountain ranges such as the Himalayas. Economic plates can move more quickly, and their collisions can be equally powerful.

We have entered into a reactionary period as self-proclaimed populists promise to segregate their countries from the outside world to achieve some form of national destiny. But it is not feasible to live in isolation, and ignoring the linkages that exist means that we are not responding to global challenges such as climate change. There may be multiple plates, but they all share one planet.

Global Firms, National Policies

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Studies of international transactions often assume that national economies function as separate “islands” or “planets.” Each has its own markets and currency, and international trade and finance occurs when the residents of one economy exchange goods and services or financial assets with those of another. The balance of payments keeps track of the transactions. But in reality firms treat the differences across nations as opportunities to increase their profits, and their decisions on basing the location of their activities–or how they report the basing of the activities–reflect this.

Multinational companies are not new entities; they can be traced back to the European trading companies that colonized the Americas, Asia and Africa. In the twentieth century, firms expanded across borders to get around trade barriers, to obtain access to raw materials, and to produce their goods more cheaply using foreign labor. Advances in the technology of shipping (container ships) and communications (Internet) spurred the development of global supply chains. Firms divided the production of goods among countries in order to manufacture them at the lowest cost before assembly into a final product. Shipments of these intermediate goods have become a major component of international trade, and intermediate inputs represent a significant portion of the value of exports .

This stratification of production has several implications, as Shimelse Ali and Uri Dadush of the Carnegie Endowment for International Peace have pointed out. Bilateral trade balances, for example, are distorted. U.S. imports from China contain a significant amount of intermediate inputs from other countries. Measuring only the value-added by Chinese firms to their exports lowers its trade surplus with the U.S. by a significant amount.

Moreover, tariffs on intermediate goods have impacts all along the global supply chain. The trade restrictions imposed by the Trump administration are rippling through the U.S. economy, raising the costs of production for those firms that depend on foreign supplies of goods that are subject to the tariffs. Daniel Ikenson of the Cato Institute has found that the U.S. transportation, construction and manufacturing sectors are those that are among those most affected by the tariffs. If the tariffs are not removed, firms will reconsider investing in new production facilities.

Global supply links also affect the current accounts of the nations where the multinationals are based. When these firms establish foreign subsidiaries in order to take advantage of cheaper costs abroad, then their home countries record less trade but more primary income resulting from the operations of the subsidiaries. The countries that receive the largest amounts of primary income include the U.S., Japan, France and Germany, all home countries of multinationals with extensive foreign operations. Net primary income does not receive as much publicity as fluctuations in the balance of trade, but the primary income balance has increased in magnitude, and in some cases dominates the current account. Japan’s net income surplus has in some years more than offset its trade deficits, while the United Kingdom’s current account deficit is due primarily to its net income deficit.

These foreign operations also give the multinational firms the opportunity to take advantage of differences in national tax systems. Stefan Avdjiev and Hyun Song Shin of the of the Bank for International Settlements and Mary Everett and Philip R. Lane of the Central Bank of Ireland have shown some of the consequences of these maneuvers. Firms can manipulate the value of their foreign profits in order to lower their tax liabilities. Until recently, the U.S. taxed multinational firms headquartered here on their global profits, with credits given for foreign taxes. The foreign profits were not taxed until they were repatriated. Firms could book profits in low-tax jurisdictions—known as “tax havens”—and keep those profits outside the U.S.

Those foreign profits could be increased by lowering the recorded cost of inputs from the U.S. and raising the value of goods sent back, thus increasing the profits recorded by the foreign subsidiary. Such “transfer prices” should be based on their market value, but in many cases there are none, which give the firms the opportunity to understate their domestic profits and overstate their foreign profits, which are subject to the lower tax. Similarly, intellectual property assets could be shifted to low-tax jurisdictions.

Thomas R. Tørsløv and Ludvig Wier of the University of Copenhagen and Gabriel Zucman of UC-Berkeley have investigated this movement of profits to tax havens. They estimate that about 40% of multinational profits are shifted to tax havens, such as Ireland, Luxembourg and Singapore.  As a result, the home countries of the multinational firms—particularly the non-haven European Union nations—lose tax revenues. The shareholders of the multinationals—particularly those based in the U.S.—are among the main winners.

Governments are well aware of the activities of the multinationals, and the loss of tax revenues. Kim Clausing of Reed College has estimated that profit shifting by U.S. multinational corporations reduces U.S. government tax revenues by more than $100 billion each year. The Organization of Economic Cooperation and Development has taken the lead in formulating policies to tackle what it calls “Base Erosion and Profit Shifting (BEPS). To date over 100 countries have agreed to participate. The recent tax code changes in the U.S. have greatly reduced the incentive for U.S. firms to record and hold profits overseas. Multinationals such as Google and Starbucks are receiving close scrutiny of their international profits, and Apple has been ordered to pay back taxes to Ireland.

The OECD’s initiative, as well as the work of advocacy groups such as the Tax Justice Network, has increased the visibility of the activities of the multinationals designed to lower taxes. But the existence of different factor costs and divergent tax codes will always provide incentives for tax lawyers and accountants to devise new ways of lowering the taxes of the multinationals. In a Westphalian world, domestic governments are reluctant to give up their sovereignty. As a result, multinationals that are much more adept in dancing around national borders will  take advantage of any opportunities they see.