Category Archives: Globalization

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.

Global Networks and Financial Instability

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The ten-year anniversary of the global financial crisis has brought a range of analyses of the current stability of the financial system (see, for example, here). Most agree that the banking sector is more robust now due to increased capital, less leverage, more prudent balance sheets and better regulation. But systemic risk is an inherent feature of finance, and a disturbance in one area can quickly spread to others through global networks.

The growth of financial markets and institutions during the 1990s and 2000s benefitted many, including those in emerging market economies that became integrated with world markets during this period. But the large-scale extension of credit to the housing sector led to property bubbles in the U.S., as well as in Ireland and Spain. The development of financial instruments such as mortgage backed securities (MBS), collateralized debt obligations (CDOs), and credit default swaps (CDS) were supposed to spread the risk of lenders in order to mitigate the impact of a negative price shock. However, these instruments and the extension of credit to subprime borrowers increased the vulnerability of financial institutions to reversals in the housing markets. Risk increased in a non-linear fashion as balance sheets became highly leveraged, and national regulators simply did not understand the nature and scale of these risks.

The holdings of assets across borders amplified the impact of the disruption of the U.S. financial markets once housing prices fell. European banks that had borrowed dollars in order to participate in the U.S. MBS markets found themselves exposed when dollar funding was no longer available. The gross flows of money between the U.S. and Europe increased the ties between their institutions and increased the fragility of their financial markets. It took the the establishment of swap networks between the Federal Reserve and European central banks to provide the necessary dollar funding.

John Kay has written about the inability to recognize and minimize systemic risk in financial systems in Other People’s Money: The Real Business of Finance. He draws from engineers the lesson that “…stability and resilience requires conscious and systematic simplification, modularity, which enables failures to be contained, and redundancy, which allows failed elements to be by-passed. None of these features—simplification, modularity, redundancy—characterized the financial system as is had developed in 2008.”

Similarly, Ian Goldin of Oxford University and Chris Kutarna examined the impact of rising financial complexity on the stability of financial systems in the period leading up to the crisis: “Cumulative connective and developmental forces produced a global financial system that was suddenly far bigger and more complex than just a decade before. This made the new hazards harder to see and simultaneously spread the dangers more widely—to workers, pensioners, and companies worldwide.”

Goldin and Mike Marithasan of KU Leuven also looked at the impact of increasing complexity on financial systems in The Butterfly Defect: How Globalization Creates Systemic Risks, and What to Do About It. They use Iceland as an example of how complex financial relationships were constructed with virtually no understanding of the consequences if they unraveled. They draw several lessons for dealing with a more complex financial networks. These include global oversight by regulators using systemic analysis, and the use of simple rules such as leverage ratios rather than complex regulations.

The Basel III regulatory regime follows this advice in a number of areas. But the basic vulnerability of financial networks remains. Yevgeniya Korniyenko, Manasa Patnam, Rita Maria del Rio-Chanon and Mason A. Porter have analyzed the interconnectedness of the global financial system in an IMF working paper, “Evolution of the Global Financial Network and Contagion: A New Approach.” They use a multilayer network framework with data on foreign direct investment, portfolio equity and debt and bank loans over the period 2008-15 to analyze the global financial network.

The authors compare the networks for the years 2009 and 2015, and report which countries are systematically important in the networks. They find that the U.S. and the U.K. appear at the top of these rankings in both of the selected years, although the cross-border holdings of U.S. financial institutions has increased over time while those of the U.K.’s institutions fell. China has moved up in the rankings, as have other Asian countries such as Singapore and South Korea. The authors conclude that “The global financial network remains most susceptible to shocks coming from large central countries…and countries with large financial systems (namely, the USA and the UK)…”

A decade after the global crisis, the possibility of the rapid propagation of a financial shock remains. There is more resiliency in those parts of the financial system that failed in 2008, but the current most vulnerable areas may not be identified until there is a new crisis. Policymakers who ignore this reality will be tripped up when the next shock occurs, and they will learn that  “The past is not dead. It’s not even past.”

The 2018 Globie: “Crashed”

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Each year I choose a book to be the Globalization Book of the Year, i.e., the “Globie”. The prize is strictly honorific and does not come with a check. But I do like to single out books that are particularly insightful about some aspect of globalization.  Previous winners are listed at the bottom.

This year’s choice is Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze of Yale University. Tooze, an historian, traces the events leading up to the crisis and the subsequent ten years. He points out in the introduction that this account is different from one he may have written several years ago. At that time Barak Obama had won re-election in 2012 on the basis of a slow but steady recovery in the U.S. Europe was further behind, but the emerging markets were growing rapidly, due to the demand for their commodities from a steadily-growing China as well as capital inflows searching for higher returns than those available in the advanced economies.

But the economic recovery has brought new challenges, which have swept aside established politicians and parties. Obama was succeeded by Donald Trump, who promised to restore America to some form of past greatness. His policy agenda includes trade disputes with a broad range of countries, and he is particularly eager to impose trade tariffs on China. The current meltdown in stock prices follows a rise in interest rates normal at this stage of the business cycle but also is based on fears of the consequences of the trade measures.

Europe has its own discontents. In the United Kingdom, voters have approved leaving the European Union. The European Commission has expressed its disapproval of the Italian government’s fiscal plans. Several east European governments have voiced opposition to the governance norms of the West European nations. Angela Merkel’s decision to step down as head of her party leaves Europe without its most respected leader.

All these events are outcomes of the crisis, which Tooze emphasizes was a trans-Atlantic event. European banks had purchased held large amounts of U.S. mortgage-backed securities that they financed with borrowed dollars. When liquidity in the markets disappeared, the European banks faced the challenge of financing their obligations. Tooze explains how the Federal Reserve supported the European banks using swap lines with the European Central Bank and other central banks, as well as including the domestic subsidiaries of the foreign banks in their liquidity support operations in the U.S. As a result, Tooze claims:

“What happened in the fall of 2008 was not the relativization of the dollar, but the reverse, a dramatic reassertion of the pivotal role of America’s central bank. Far from withering away, the Fed’s response gave an entirely new dimension to the global dollar” (Tooze, p. 219)

The focused policies of U.S. policymakers stood in sharp contrast to those of their European counterparts. Ireland and Spain had to deal with their own banking crises following the collapse of their housing bubbles, and Portugal suffered from anemic growth. But Greece’s sovereign debt posed the largest challenge, and exposed the fault line in the Eurozone between those who believed that such crises required a national response and those who looked for a broader European resolution. As a result, Greece lurched from one lending program to another. The IMF was treated as a junior partner by the European governments that sought to evade facing the consequences of Greek insolvency, and the Fund’s reputation suffered new blows due to its involvement with the various rescue operations.The ECB only demonstrated a firm commitment to its stabilizing role in July 2012, when its President Mario Draghi announced that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.”

China followed another route. The government there engaged in a surge of stimulus spending combined with expansionary monetary policies. The result was continued growth that allowed the Chinese government to demonstrate its leadership capabilities at a time when the U.S. was abandoning its obligations. But the ensuing credit boom was accompanied by a rise in private (mainly corporate) lending that has left China with a total debt to GDP ratio of over 250%, a level usually followed by some form of financial collapse. Chinese officials are well aware of the domestic challenge they face at the same time as their dispute with the U.S. intensifies.

Tooze demonstrates that the crisis has let loose a range of responses that continue to play out. He ends the book by pointing to a similarity of recent events and those of 1914. He raises several questions: “How does a great moderation end? How do huge risks build up that are little understood and barely controllable? How do great tectonic shifts in the global world order unload in sudden earthquakes?” Ten years after a truly global crisis, we are still seeking answers to these questions.

Previous Globie Winners:

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

 

Empires, Past and Present

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Economists rarely write about “empires,” unless they are referring to historical examples such as the Roman empire. But Thomas Hauner of the Federal Reserve Bank of Minneapolis,  Branko Milanovic of the Graduate Center of City University of New York and Suresh Naidu of Columbia University have presented a study of empires using criteria drawn from an economics classic, John Hobson’s Imperialism (1902). The same criteria can be used to examine whether any empires exist today.

Hobson was not a Marxist, but his work greatly influenced later Marxist writers who wrote about imperialism, including Vladimir Lenin, Rudolf Hilferding and Rosa Luxemburg. Hobson believed that there was chronic underconsumption in advanced capitalist countries due to unequal distributions of income. This lowered the return on domestic investment, and as a result the owners of financial capital turned to foreign markets where returns would be higher. These investors relied on their governments to guarantee the safety of their foreign holdings from seizure.

Hauner, Milanvic and Naidu demonstrate that there was a high degree of inequality within the advanced capitalist countries in the late 19th century. The foreign assets held by wealthy investors in Britain and France expanded greatly during this period, and these assets generated rates of return higher than those available from domestic investments. They also present evidence of a linkage between the accumulation of foreign assets and militarization that led to World War I. These results are consistent with Hobson’s work.

Hobson’s empires established positive net international investment positions (NIIP) and received income from these foreign investments. The payments appear in the current account of the balance of payments as “net primary income.” This component of the current account records the difference between payments received by domestic residents for providing productive resources, such as their labor, financial resources or land, to foreigners minus the payments made to foreigners for their productive resources made available to the domestic economy. For most countries, receipts and payments on financial assets are the largest component of their net primary income.

Great Britain was a financial center and the preeminent creditor nation during the zenith of its empire, and a net recipient of foreign income. It earned net income worth 5.4% of GDP in the period 1874-1890, and 6.8% from 1891 to 1913 (Matthews, Feinstein and Odling-Smee 1982). The surpluses were large enough to offset a trade deficit and allow the country to continue to invest abroad and expand their foreign holdings.

What are the largest creditor nations today? Are they also Hobsonian empires? Japan is the leading creditor nation, with a net international investment position of $2.8 trillion in 2015, which represented 67% of its GDP. It earned $165.88 billion in net primary income, worth 3.8% of its GDP. Germany is also a creditor nation, with a NIIP of about $1.5 trillion (45% of GDP) in 2015 and net income of $74.6 billion (2.2% of its GDP).

But Japan and Germany nations do not fulfill the other criteria to be called empires. They do not have the disparities in wealth that the U.S. and many developing countries possess. Their Gini coefficients are almost identical: 32.1 for Japan and 31.4 for Germany. These are similar in magnitude to those of other European countries, higher than those of the Scandinavian nations but below those of Portugal and Spain.

Moreover, the two nations are not militaristic powers. Japan’s constitution forbids the use of force, although the country does have Self-Defense Forces. Prime Minister Shinzo Abe is seeking to amend the country’s constitution in order to clarify the rules governing the disposition of these troops. Germany is part of NATO, but the foreign deployment of German forces is strictly supervised by Parliament.

The situation of other large countries is more anomalous. China is a leading creditor nation, with a NIIP in 2015 only slightly lower than Germany’s and equal to 194% of its GDP. But that country registered a deficit of net primary income of $41.8 billion. On the other hand, the country with the largest inflow of income in absolute terms was the U.S., a debtor nation with a NIIP of -$7.8 trillion in 2015, worth about 45% of GDP. Its net income inflow of $204.5 billion represented 1.1% of its GDP.

The explanation for these seemingly inconsistent results lies with the composition of the external assets and liabilities. The U.S. is “long equity, short debt,” with assets largely composed of foreign direct investments (FDI) and portfolio equity, and liabilities primarily in the form of debt (bonds, such as U.S. Treasury securities, or bank loans). In 2015, for example, 60% of its assets were held in the form of FDI or portfolio equity, which earn an equity premium because of their riskier nature. China, on the other hand, is “long debt and short equity,” where the debt includes the central bank’s foreign reserves held in the form of U.S. Treasury bonds. Debt assets and foreign reserves constituted 79% of China’s foreign assets in 2015, and the returns on these have been quite low in recent years. FDI and portfolio equity liabilities, on the other hand, accounted for 74% of the external liabilities.

The unusual nature of these income flows have attracted great attention. Yu Yongding of China’s Academy of Social Sciences, for example, has written about his country’s “irrational IIP structure.” He attributes this to an undervalued exchange rate that has allowed the country to have surpluses in both the current and capital accounts that were balanced by increases in foreign reserves, as well as government policies that favored FDI from abroad.

The positive return that the U.S. receives has been called an “exorbitant privilege” that is due to the status of the dollar as a reserve currency. In 1966 Emile Despres of Stanford University, Charles P. Kindleberger of MIT and Walter S. Salant of the Brookings Institution wrote that the configuration of the U.S. balance of payments was due to its status as the “world’s banker”, issuing short-term liabilities in exchange for long-term assets. More recently, Pierre-Olivier Gourinchas of UC-Berkeley and Hélène Rey of the London Business School updated this description of the U.S. to the “world venture capitalist.”

The global financial crisis might have ended this status of the U.S., but the influence of the U.S. economy and its monetary policies has not diminished. Changes in U.S. interest rates have widespread effects on capital flows and credit creation. Several recent studies, including one by Òscar Jordàof UC-Davis, Moritz Schularick of the University of Bonn and Alan Taylor of UC-Davis, have referred to the existence of a global financial cycle that is very responsive to U.S. monetary policy. Similarly, Matteo Iacoviello and Gaston Navarro  of the Federal Reserve Board have written about the spillover effects of U.S. interest rates on foreign economeis.

It may be time for a new definition of imperialism. If the U.S. possesses an empire, it is based on its ownership of foreign capital that it accumulates in return for the issuance of “safe assets.” It takes advantage of this position to invest in more lucrative equity. In addition, it hosts the largest and most liquid financial markets and networks. Moreover, the U.S. government has shown its willingness to use financial sanctions as a policy tool.

With respect to the other attributes of 19thcentury empires, we no longer send Marines to Central America to safeguard our foreign holdings. But our military spending greatly exceeds that of other nations. Wealth is heavily concentrated; the richest U.S. families—those in the top 1% of the distribution of wealth—own 40% of the wealth in this country. Those assets undoubtedly include direct and indirect ownership in foreign enterprises, which contribute to the returns they receive.

What could end this arrangement? The renminbi and the euro are rival currencies, but it is doubtful that they will attain the global status of the dollar. Under ordinary circumstances, one might expect the U.S. position to continue for the foreseeable future. But these are not ordinary times. The Trump administration seems ready to shred a wide range of international agreements, such as those that established the World Trade Organization and the North American Free Trade Association. Moreover, the tax legislation passed last year that lowered personal and corporate tax rates is pushing up the government’s budget deficit. The Congressional Budget Office’s projection for this fiscal year’s deficit has risen from $563 billion to $804 billion and is projected to reach $1 trillion by 2020. Will U.S. Treasury securities continue to be viewed as safe?

The record of transitions in international monetary regimes does not bode well for the future. The gold standard collapsed in the 1930s as governments sought to escape the world-wide contraction in global economic activity. The Bretton Woods regime began to disintegrate when the Nixon administration ended the conversion of the dollar reserves of foreign central banks into gold in 1971. None of these regime ends were planned and they led to further instability. The end of America’s hegemonic financial position has long been forecasted–and avoided. But the shockwaves of the global financial crisis are still taking place, and eventually may be even more disruptive than we ever imagined.

Can Globalization Be Reversed?

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The wide-scale imposition of tariffs by the Trump administration is part of a larger effort to undo the expansion of markets around the globe and ensure that the goods consumed in the U.S. will be produced here. Will it be successful? And what would a world that represented a retreat from the globalization of the 1990s and early 2000s look like?

Martin Sandbu of the Financial Times believes that the open world economy “can withstand the assault.” He points out that the emerging market economies that have benefitted from the increase in international trade have an interest in maintaining the current regime. Moreover, it will be difficult to replace global supply chains with production facilities in each economy where a firm sells its products. Finally, limiting overseas expansion of markets will do nothing to address the problem it is supposed to correct: the stagnant wages of relatively low-skilled people. There are policies to help those whose jobs have been eliminated by technology, but these include better educational opportunities and health care, not limitations on trade.

While globalization will not be replaced by national autarchies, it is possible to imagine more narrow organizations of production and finance. The increase in the number of regional trade pacts will accelerate If the World Trade Organization is undermined by the Trump administration. Whether or not regional trade agreements are the source of trade creation or diversion is an empirical issue. Research by Caroline Freund of the Peterson Institute for International Economics and Emanuel Ornelas of Sao Paulo School of Economics-FGV indicates that such pacts in the past were beneficial for trade. But there is no guarantee that this outcome will continue in the future, particularly if the regional pacts replace wider agreements.

The world could divide into competing spheres of influence. China is taking advantage of the withdrawal of the U.S. from international pacts to advance its Belt and Road Initiative that will link it to resource-rich developing economies in Asia and Africa as well as markets in Europe. Advocates of British withdrawal from the European Union claim that there are better opportunities in the “Anglosphere” of English-speaking countries such as the U.S. and Australia.

But the Trump administration has exhibited animus to even regional pacts such as NAFTA, and seemingly favors bilateral pacts guided by mercantilist goals. Such an approach would be a serious problem for U.S. based multinationals that have integrated production lines across the borders with Mexico and Canada. Nor will the governments of those agree to mercantilist arrangements that are designed to ensure bilateral trade surpluses for the U.S.

A world of tariffs and quotas, moreover, would also be a step towards increased government controls on the private sector. Anne Krueger of Johns Hopkins points out that quotas, such as those on steel that South Korea has agreed to, must be administered by either the Korean or U.S. government. Similarly, exemptions from tariffs must be granted by a bureaucracy that reviews applications from private firms. These grants of authority open up opportunities for corruption. They also act as barriers to entry for new firms, and lessen incentives to innovate. All this adds to the higher costs that consumers and those who rely on imported intermediate goods will pay.

Perhaps the most self-defeating counter-globalization measure would be to lower immigration. While most of the benefits of immigration flow to the migrants themselves, there is also a “migration surplus” for the economy that hosts them. The tax payments of migrants can be used to pay rising Social Security payments at a time when the native U.S. population is aging.  Moreover, immigrants have a strong record of establishing new businesses. The Center for American Entrepreneurship reports that 43% of firms listed in the 2017 Fortune 500 were founded or co-founded by first- or second-generation migrants.

Not all movements towards globalization were beneficial for those countries that opened up their borders. In the area of finance, financial flows led to the Asian crisis of 1997-98 and the global financial crisis of 2008-09, while their impact on growth is slim at best. The IMF has renounced its previous advocacy of capital account deregulation and now views capital controls as part of a government’s toolkit of macroprudential measures to stabilize the financial sector.

Moreover, Dani Rodrik of the Kennedy School has pointed out that the hyperglobalization drive of the 1980s and 1990s pushed trade agreements beyond their “traditional focus on import restrictions and impinged on domestic policies…” Rodrik argues that some of the recent trade pacts are designed to increase the revenues of multinational firms, and their redistributive effects will overwhelm any increases in efficiency.

But attempting to impose a system of nationalistic managed trade that limits the movements of people is inherently difficult, and will lead to widespread government intervention. Workers and firms who benefit from such measures will be outnumbered by those who lose export opportunities and those who must pay higher domestic prices. Over time, firms will cut back on investments if they feel the need to secure government approval. All this will lower productivity in economies where productivity growth is already depressed. There is a need for a better-designed globalization, but what we are seeing is a movement to a world of national barriers that will only fuel xenophobia and hamper long-term growth.

A Guide to the (Financial) Universe: Part III

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Parts I and II of this Guide appear here and here.

4.      Stability and Growth

Is the global financial system safer a decade after the last crisis? The response to the crisis by central banks, regulatory agencies and international financial institutions has increased the resiliency of the system and lowered the chances of a repetition. Banks have deleveraged and possess larger capital bases. The replacement of debt by equity financing should provide a more stable source of finance.

Indicators of financial volatility, such as the St. Louis Fed Financial Stress Index, currently show no signs of sudden shifts in market conditions. The credit-to-GDP gap, developed by the Bank of International Settlements (BIS) as an early warning indicator of systemic banking crises, exhibits little evidence of excessive credit booms. One exception is China, although its gap has come down.

But increases in U.S. interest rates combined with an appreciating dollar could change these conditions. Since the financial crisis, financial flows have appeared to be driven in part by a global financial cycle that is governed by U.S. interest rates as well as asset market volatility. This has led Hélène Rey of the London Business School to claim that the Mundell-Fleming trilemma has been replaced by a dilemma, where the only choice policymakers face is whether or not they should use capital controls to preserve monetary control. Eugenio Cerutti of the IMF, Stijn Claessens of the BIS and Andrew Rose of UC-Berkeley, on the other hand ,have offered evidence that the empirical importance of any such cycle is limited. Moreover, Michael W. Klein of Tufts University and Jay C. Shambaugh of George Washington University in one study and Joshua Aizenman of the University of Southern California, Menzie Chinn of the University of Wisconsin and Hiro Ito of Portland State University in another have found that flexible exchange rates can affect the sensitivity of an economy to foreign policy changes and afford some degree of policy autonomy.

A rise in U.S. rates, however, will increase the cost of borrowing in dollars. The volume of credit flows denominated in dollars reflects the continuing predominance of the dollar in international financial markets. Dollar-denominated credit to emerging market economies, for example, rose by 10% in 2017, driven primarily by a rise in the issuance of debt securities. Higher interest rates, a depreciating currency and a deteriorating international trade environment can quickly downgrade the creditworthiness of emerging market borrowers.

Other potential sources of stress remain. One of these is the lack of adequate “safe assets,” which serve as collateral for lending. U.S. Treasury bonds are utilized for this purpose, but in the run-up to the global crisis mortgage-based securities (MBS) with the highest ratings also served that function. Their disappearance leaves a need for other privately-provided safe assets, or alternatives issued by the international public agencies. Moreover, doubts about U.S. fiscal solvency could lead to doubts about the creditworthiness of the U.S. government securities.

Claudio Borio of the BIS perceives another flaw in the international monetary system: “excess financial elasticity” that contributes to financial imbalances. The procyclicality of finance is heightened during boom periods by capital inflows, and the spread of easy monetary conditions in core countries to the rest of the world is facilitated through monetary regimes. The impact of the regimes includes the decision of policymakers to resist currency appreciation which affects their interest rates, and the role of dominant currencies such as the dollar. Borio calls for greater international cooperation to mitigate the volatility of the financial cycle.

Dirk Schoenmaker of the Duisenberg School of Finance and VU University Amsterdam has drawn attention to a fundamental tension within the international system. He suggests that there is a financial trilemma, with only two of these three characteristics of a financial system as feasible: International financial integration, national financial policies and financial stability. A nation that wants to enjoy the benefits of cross-border capital flows needs to coordinate its regulatory activities with those of other countries. Otherwise, banks and other institutions will take advantage of discrepancies across borders in the rules governing their activities to find the least onerous regulations and greatest room for expansion.

These concerns about stability could be accepted if financial development had a positive impact on economic growth. But Boris Cournède, Oliver Denk and Peter Hoeller of the OECD,  in a review of the literature on the relationship of the financial sector and economic growth, report that above a threshold of financial development the linkage with growth is negative (see also here). Their results indicate that this reversal occurs when the financial expansion is based on credit rather than equity markets. Similarly, Stephen G. Cecchetti and Enisse Kharroubi of the BIS (see also here) report that financial development can lower productivity growth.

In addition, it has long been acknowledged that there is little evidence linking international financial flows to growth (see, for example, the summary of this work by Maurice Obstfeld of the IMF (and formerly of UC-Berkeley)).  More recently, Joshua Aizenman of the University of Southern California, Yothin Jinjarik of the University of Wellington and Donghyun Park of the Asian Development Bank have shown that the relationship of capital flows and growth depends on the form of capital. FDI flows possess a robust relationship with growth, while the linkage with other equity is smaller and less stable. The impact of FDI may depend on the development of the domestic financial sector. Debt flows in normal times do not reinforce growth, but can contribute to the probability of a financial crisis.

The impact of international financial flows on income inequality is also a subject of concern. Davide Furceri and Prakash Loungani of the IMF found that capital account liberalization reforms increase inequality and reduce the labor share of income. Furceri, Loungani and Jonathan Ostry also report that policies to promote financial globalization have led on average to limited output gains while contributing to significant increases in inequality. Distributional effects are more pronounced in those countries with low financial depth and inclusion, and where liberalization is followed by a crisis. A similar result was reported by Silke Bumann of the Max Planck Institute for Evolutionary Biology and Robert Lensink of the University of Groningen.

The change in the international financial system that may be the least understood is the evolution of FDI, which has grown in recent decades while the use of bank credit has fallen. FDI flows are increasingly routed thought countries such as Luxembourg and Ireland for the purpose of tax minimization. Moreover, the profits generated by foreign subsidiaries can be reinvested and form the basis of further FDI. Quyen T. K. Nguyen of the University of Reading asserts that such financing may be particularly important for operations in emerging market economies where domestic finance is limited. FDI flows also include intra-firm financing, a form of debt, and therefore FDI may be more risky than commonly understood.

5.     Conclusions

As a result of the substantial capital flows of the 1990s and early 2000s, the scope of financial markets and institutions now transcends national borders, and this expansion is likely to continue. While financial openness as measured by external assets and liabilities has not risen since the global crisis, this measurement is misleading. Emerging market economies with growing GDPs but less financial openness are becoming a larger component of the global aggregate. But financial openness and GDP per capita are correlated, and the populations of those countries will engage in more financial activity as their incomes increase.

A stable international financial system that promotes inclusive growth is a global public good. Global public goods face the same challenge as domestic public goods, i.e., a failure of markets to provide them. In the case of a global public good, the failure is compounded by the lack of an incentive for any one government to supply it.

The central banks of the advanced economies did coordinate their activities during the crisis, and since then international financial regulation has responded to the growth of global systematically important banks. But the growth of multinational firms that manage global supply chains and international financial institutions that move funds across borders poses a continuing challenge to stability. In addition, while the United Kingdom and the U.S. served as a financial hegemons in the past, today we have nations with small economies but extremely large financial sectors that reroute financial flows across border, and their activities are often opaque.

The global financial crisis demonstrates how little was understood of the fragility of the financial system that had built up around mortgage-backed securities. Regulators need to understand and monitor the assets and liabilities that have replaced them if they are not to be caught by surprise by the outcome of the next round of financial engineering. If “eternal vigilance is the price of liberty,” it is also a necessary condition for a stable financial universe.

A Guide to the (Financial) Universe: Part II

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(Part I of this Guide appears here.)

3. Crisis and Response

The global crisis revealed that the pre-crisis financial universe was more fragile than realized at the time. Before the crisis, this fragility was masked by low interest rates, which were due in part to the buildup of foreign reserves in the form of U.S. securities by emerging market economies. The high ratings that mortgage backed securities (MBS) in the U.S. received from the rating agencies depended on these low interest rates and rising housing prices. Once interest rates increased, however, and housing values declined, mortgage borrowers—particularly those considered “subprime”—abandoned their properties. The value of the MBS fell, and financial institutions in the U.S. and Europe sought to remove them from their balance sheets, which reinforced the downward spiral in their values.

The global crisis was followed by a debt crisis in Europe. The governments of Ireland and Spain bolstered their financial institutions which had also lent extensively to the domestic housing sectors, but their support led to a deterioration in their own finances. Similarly, the safety of Greek government bonds was called into question as the scope of Greek deficit expenditures became clear, and there were concerns about Portugal’s finances.

Different systems of response and support emerged during the crises. In the case of the advanced economies, their central banks coordinated their domestic policy responses. In addition, the Federal Reserve organized currency swap networks with its counterparts in countries where domestic banks had participated in the MBS markets, as well as several emerging market economies (Brazil, Mexico, South Korea and Singapore) where dollars were also in demand. The central banks were then able to provide dollar liquidity to their banks. The European Central Bank provided similar currency arrangements for countries in that region, as did the Swiss National Bank and the corresponding Scandinavian institutions.

The emerging market countries that were not included in such arrangements had to rely on their own foreign exchange reserves to meet the demand for dollars as well as respond to exchange rate pressures. Subsequently, fourteen Asian economies formed the Chiang Mai Initiative Multilateralization, which allows them to draw upon swap arrangements. China has also signed currency swap agreements with fourteen other countries.

In addition, emerging market economies and developing economies received assistance from the International Monetary Fund, which organized arrangements with 17 countries from the outbreak of the crisis through the following summer. The Fund had been severely criticized for its policies during the Asian crisis of 1997-98, but its response to this crisis was very different. Credit was disbursed more quickly and in larger amounts than had occurred in past crises, and there were fewer conditions attached to the programs. Countries in Asia and Latin America with credible records of macroeconomic policies were able to boost domestic spending while drawing upon their reserve holdings to stabilize their exchange rates. The IMF’s actions contributed to the recovery of these countries from the external shock.

The IMF played a very different role in the European debt crisis. It joined the European Commission, which represented European governments, and the European Central Bank to form the “Troika.” These institutions made loans to Ireland in 2010 and Portugal in 2011 in return for deficit-reduction policies, while Spain received assistance in 2012 from the other Eurozone governments. In 2013 a banking crisis in Cyprus also required assistance from the Troika.These countries eventually recovered and exited the lending programs.

Greece’s crisis, however, has been more protracted and the provisions of its program are controversial. The IMF and the European governments have been criticized for delaying debt reduction while insisting on harsh budget austerity measures. The IMF also came under attack for suborning its independence by joining the Troika, and its own Independent Evaluation Office subsequently published a report that raised questions about its institutional autonomy and accountability.

In the aftermath of the crisis, new regulations—called “macroprudential policies”—have been implemented to reduce systemic risk within the financial system. The Basel Committee on Banking Supervision, for example, has instituted higher bank capital and liquidity requirements. Other rules include restrictions on loan-to-value ratios. These measures are designed both to prevent the occurrence of credit bubbles and to make financial institutions more resilient. A European Banking Authority has been established to set uniform regulations on European banks and to assess risks. In the U.S., a Financial Stability Oversight Council was given the task of identifying threats to financial stability.

The crisis also caused a reassessment of capital account restrictions. The IMF, which had urged the deregulation of capital accounts before the Asian crisis of 1997-98, published in 2012 a new set of guidelines, named the “institutional view.” The Fund acknowledged that rapid capital flows surges or outflows could be disruptive, and that under some circumstances capital flow management measures could be useful. Capital account liberalization is appropriate only when countries reach threshold levels of institutional and financial development.

One legacy of the response to the crisis is the expansion of central bank balance sheets. The assets of the Bank of England, the Bank of Japan, the European Central Bank (ECB) and the Federal Reserve rose to $15 trillion as the central banks engaged in large-scale purchases of assets, called “quantitative easing”. The Federal Reserve ceased purchasing securities in 2014, and the ECB is expected to cut back its purchases later this year.  But the unwinding of these holdings is expected to take place gradually over many years, and monetary policymakers have signaled that their balance sheets are unlikely to return to their pre-crisis sizes.

(to be continued)

A Guide to the (Financial) Universe: Part I

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A Guide to the (Financial) Universe: Part 1

  1.     Introduction

A decade after the global financial crisis, the contours of the financial system that has emerged from the wreckage are becoming clearer. While the capital flows that preceded the crisis have diminished in size, most of the assets and liabilities they created remain. But there are significant differences between advanced economies and emerging markets in their size and composition, and those nations that are financial centers hold large amounts of international investments. Moreover, the predominance of the U.S. dollar for official and private use seems undiminished, if not strengthened, despite the widespread predictions of its decline. A guide to this new financial universe reveals a number of features that were not anticipated ten years ago.

2.       External Assets and Liabilities

Financial globalization is the result of the flow of capital across borders and the integration of domestic financial markets. Financial flows like trade flows increased during the first wave of globalization during the 19th century, which ended with the outbreak of World War I. After World War II, trade and capital flows started up again and grew rapidly. In the mid-1990s financial flows accelerated more rapidly than trade, particularly in the advanced economies, and peaked on the eve of the global financial crisis.

Philp R. Lane of the Central Bank of Ireland and Gian Milesi-Ferretti of the IMF in their latest survey of international financial integration (see also here) provide an update of their data on the size and composition of the external balance sheets. Financial openness, as measured by the sum of gross assets and liabilities, for most countries has remained approximately the same since the crisis. But its magnitude differs greatly amongst countries.  Financial openness in the advanced economies excluding the financial centers, as measured by the sum of external assets and liabilities scaled by GDP, is over 300%, which is approximately three times as large as the corresponding figure in the emerging and developing economies. This is consistent with the large gross flows among the advanced economies that preceded the crisis. However, the same measure in the financial centers is over 2,000%. These centers include small countries with large financial sectors, such as Ireland, Luxembourg, and the Netherlands, as well as those with larger economies, such as Switzerland and the United Kingdom.

Some advanced economies, such as Germany and Japan, are net creditors, while others including the U.S. and France are net debtors. The emerging market nations excluding China are usually debtors, while major oil exporters are creditors. These net positions reflect not only the acquisition/issuance of assets and liabilities, but also changes in their values through price movements and exchange rate fluctuations. Changes in these net positions can influence domestic expenditures through wealth effects. They affect net investment income investment flows, although these are also determined by the composition of the assets and liabilities (see below). In many countries, such as Japan and the United Kingdom, international investment income flows have come to play a large role in the determination of the current account, and can lead to a divergence of Gross Domestic Product and Gross National Income.

The external balance sheets of the advanced economies are often characterized by holdings of equity and debt liabilities—“long equity, short debt’’—while the emerging market economies hold large amounts of debt and foreign exchange reserves and are net issuers of equity, particularly FDI—“long debt and foreign reserves, short equity.” The acquisition of foreign reserve holdings by emerging Asian economies is responsible for much of the “Lucas paradox,” i.e., the “uphill” flow of capital from emerging markets to advanced economies. However, there has also been a rise in recent years n the issuance of bonds by non-financial corporations in emerging markets, in some cases through offshore foreign affiliates.

As FDI has increased, the amount of investment income accounted for by FDI-related payments has risen. In the case of the emerging markets, these payments now are responsible for most of their investment income deficit, while the amounts due to banks and other lenders have diminished. FDI payments for the advanced economies, on the other hand, show a surplus, reflecting in part their holdings of the emerging market economies’ FDI.

The balance sheets of the international financial centers also include large amounts of FDI assets and liabilities. These holdings reflect these countries’ status as financial intermediaries, and funds are often channeled through them for tax purposes. The double-counting of investment that this entails overstates the actual value of foreign investment. The McKinsey Global Institute in its latest report on financial globalization has estimated that if such double-counting was excluded, the value of global foreign investment would fall from 185 percent of GDP to 140 percent.

The composition of assets and liabilities has consequences for economic performance. First, equity and debt have different effects on recipient economies. Portfolio equity inflows lower the cost of capital in domestic markets, and can enhance the liquidity of domestic stock markets and the transparency of firms that issue stock. In addition, M. Ayhan Kose of the World Bank, Eswar Prasad of Cornell University and Marco E. Terrones of the IMF have shown that equity, and in particular FDI, increases total factor productivity growth. Philip R. Lane of the Central Bank of Ireland and Peter McQuade of the European Central Bank, on the other hand, reported that debt inflows are associated with the growth of domestic credit, which can lead to asset bubbles and financial crises. Second, the differences in the returns on equity and debt affect the investment income flows that correspond to the assets and liabilities. Equity usually carries a premium as an incentive for the risk it carries. The U.S. registers a surplus on its investment income despite its status as a net debtor because of its net positive holdings of equity.

Third, the mix of assets and liabilities influences a country’s response to external shocks. FDI is relatively stable, but its return is state-contingent. Debt, on the other hand, is more volatile and in many cases can be withdrawn, but its return represents a contractual commitment. As a result, the mix of equity and debt on a country’s external balance sheet affects its net position during a crisis as well as its net investment income balance.

The change in the value of equity, for example, can depress or raise a country’s balance sheet during a crisis. Pierre Gourinchas of UC-Berkeley, Hélène Rey of the London Business School and Govillot of Ecole des Mines (see also here) have characterized the U.S. with its extensive holdings of foreign equity as the world’s “venture capitalist.”  Gourinchas, Rey and Kai Truempler of the London Business School showed that the loss of value in its equity holdings during the global crisis provided a transfer of wealth to those countries that had issued the equity.  Those nations that had issued equity, on the other hand, avoided some of the worst consequences of the crisis.

This analysis of external balance sheets, however, assumes that the assets and liabilities are pooled. Stefan Avdjiev, Robert N. McCauley and Hyun Song Shin of the Bank for International Settlements (see also here)  have pointed out that public assets, such as the foreign exchange reserves of the central bank, may not be available to the private sector. South Korea, for example, had a positive net international investment position that included foreign currency assets, which appreciated in value when the global crisis struck. Nonetheless, corporations and banks had issued dollar-denominated liabilities, and their value also rose. The country was one of those that entered into a currency swap arrangement with the Federal Reserve.

Eduardo A. Cavallo and Eduardo Fernández-Arias of the Inter-American Development Bank and and Matías Marzani of Washington University in St. Louis also investigate whether foreign assets provide protection in the case of a shock. They report that portfolio equity assets as well as reserves lower the probability of a banking crisis. Portfolio equity, like reserves, are relatively liquid and therefore residents can draw upon them during periods of volatility.

The difference between private and public assets liabilities has been investigated by Andreas Steiner of Grongien University and Torsten Saadma of the University of Mannheim. They calculate a measure of private financial openness that excludes the reserve assets of central banks as well as loans based on development aid. In the case of emerging markets and developing economies, their measure differs significantly from the standard measure, and results in different findings for the linkage of financial openness and growth.

Avdjiev, McCauley and Shin of the BIS also point out that balance sheets are measured on a national basis. But assets and liabilities may be held through foreign affiliates. International banks, for example, have foreign units with claims and liabilities. If these are consolidated on their parents’ balance sheet, then a very different assessment of the banks’ international creditworthiness may emerge. Similarly, non-financial firms may obtain credit through their foreign branches that borrow in the offshore debt markets. The credit inflow could hamper the ability of domestic authorities to stabilize the financial system. External balance sheets measured on a national basis may give a misleading picture of domestic institutions’ foreign linkages.

(to be continued)

2017 Globie: “Grave New World”

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Once a year I choose a book that deals with an aspect of globalization in an interesting and illuminating way, and bestow on it the “prize” of the Globalization Book of the Year (known as the “Globie”). The prize is strictly honorific—no check is attached! But I enjoy drawing attention to an author who has an insight on the process of globalization.  Previous winners are listed below.

This year’s Globie goes to Stephen D. King for Grave New World: The End of Globalization, The Return of History. King is senior economic adviser at HSBC Holdings, where he was chief economist from 1998 to 2015. He is the author of Losing Control: The Emerging Threats to Western Prosperity, which won the Globie in 2010, and therefore is the first two-time winner.

In the new book King addresses the current status of globalization, and how it may evolve in the future. In the book he makes six claims:

  • Globalization is not irreversible;
  • Technology can both enable globalization and destroy it;
  • Economic development that reduces inequality between states but reinforces domestic inequality creates a tension between a desire for gains in global living standards and social stability at home;
  • Migration in the 21st century will affect domestic stability;
  • The international institutions that have helped govern globalization have lost their credibility;
  • There is more than one version of globalization.

King is particularly perceptive in pointing out alternative viewpoints to those usually espoused in Western media. In Chapter 7, for example, he gives six different perspectives on how globalization has affected economic welfare. He begins with the Western version, and follows it with the Chinese, Ottoman, Russian, Persian and African versions. Each region sees history filtered through its own experiences and comes to very different conclusions on the benefits and costs of globalization.

Differences over globalization also exist within Western nations, as recent elections have shown. King points out that supporters of Donald Trump in the U.S. were concerned about immigration and terrorism, while Hilary Clinton’s supporters were worried about inequality. Nor are these concerns confined to the U.S., as the Brexit vote revealed. Part of these divisions are responses to the hardships and dislocations caused by the global financial crisis. But whatever the source, this upheaval hastens a retreat by Western countries from global engagement.

While the Western economies are withdrawing from international commitments, others are actively pursuing their own global agendas. China’s Silk Road initiative, for example, extends its trade ties with central Asia and Europe. The Asian Infrastructure Investment Bank bolsters China’s neighbors’ capacity to engage in more transactions. At some point India will undoubtedly respond with its version of an Asian initiative.

King readily admits that his view of the future is “unsettling.” Our faith in technology and markets has not led to the widespread adoption of Western values or shared prosperity. The challenge is to formulate international mechanisms that mitigate market failures, including inequality. A vision based on every nation following its own interests is not likely to achieve that goal.

Previous Globie Winners

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

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

2016    Branko Milanovic: Global Inequality