Category Archives: Globalization

Trilemmas and Financial Instability

Leave a reply

Whether or not the international monetary trilemma (the choice facing policymakers among monetary autonomy, capital mobility and a fixed exchange rate) allows policymakers the scope for policy autonomy has been the subject of a number of recent analyses (see here for a summary). Hélène Rey of the London Business School has claimed that the global financial cycle constrains the ability of policymakers to affect domestic conditions regardless of the exchange rate regime. Michael Klein of the Fletcher School at Tufts and Jay Shambaugh of George Washington University, on the other hand, have found that exchange rate flexibility does provide a degree of monetary autonomy. But is monetary policy sufficient to avoid financial instability if accompanied by unregulated capital flows ?

A recent paper by Maurice Obstfeld, Jonathan D. Ostry and Mahvash S. Qureshi of the IMF’s Research Department examines the impact of the trilemma in 40 emerging market countries over the period of 1986-2013. They report that the choice of exchange rate regime does affect the sensitivity of domestic financial variables, such as domestic credit, house prices and bank leverage, to global conditions. Economies with fixed exchange rate regimes are more impacted by changes in global market volatility than those with flexible exchange rate regimes. They also find that capital inflows are sensitive to the choice of exchange rate regime.

However, the insulation properties of flexible exchange rates are not sufficient to protect a country from financial instability. Maurice Obstfeld of the IMF and Alan M. Taylor of UC-Davis in a new paper point out that while floating rates and capital mobility allow policy makers to focus on domestic objectives, “…monetary policy alone may be a relatively ineffective tool for addressing potential financial stability problems….exposure to global financial shocks and cycles, perhaps the result of monetary or other developments in industrial-country financial markets, may overwhelm countries even when their exchange rates are flexible.”

Global capital flows can adversely affect a country through multiple channels. The Asian financial crisis of 1998 demonstrated the impact of sudden stops, when inflows of foreign capital turn to outflows. The withdrawal forces adjustments in the current account and disrupts domestic financial markets, and can trigger a devaluation of the exchange rate. The fall in the value of the currency worsens a country’s situation when there are liabilities denominated in foreign currencies, and this balance sheet effect can overwhelm the expansionary impact of the devaluation on the trade balance.

The global financial crisis of 2008-09 showed that gross inflows and outflows as well as net flows can lead to increased financial risk. Before the crisis there was a tremendous buildup of external assets and liabilities in the advanced economies. Once the crisis began, the volatility in their financial markets was reinforced as residents liquidated their foreign assets in response to their need for liquidity (see Obstfeld here or here).

International financial integration can also raise financial fragility before a crisis emerges. Capital flows can be highly procyclical, fluctuating in response to business cycles (see here and here). Many studies have shown that the inflows result in increases in domestic credit that foster more economic activity (see here for a summary of recent papers). Moritz Schularick of the Free University of Berlin and Alan Taylor of UC-Davis (2012)  have demonstrated that these credit booms can result in financial crises.

What can governments do to forestall international financial instability?  Dirk Schoenmaker of VU University Amsterdam and the Duisenberg School of Finance has offered another trilemma, the financial trilemma, that addresses this question (see also here). In this framework, a government can choose two of the following three financial objectives: national financial regulatory policies, international banking with international regulation, and/or financial stability. For example, financial stability can occur when national financial systems are isolated, such as occurred under the Bretton Woods system. Governments imposed barriers on capital integration and effectively controlled their financial systems, and Obstfeld and Taylor point out that the Bretton Woods era was relatively free of financial crises. But once countries began to remove capital controls and deregulated their financial sectors in the post-Bretton Woods era, financial crises reappeared.

International financial integration combined with regulatory cooperation could lessen the consequences of regulation-shopping by global financial institutions seeking the lowest burden. But while the Financial Stability Board and other forums may help regulators monitor cross-border financial activities and design crisis resolution schemes, such coordination may be necessary but not sufficient to avoid volatility. Macroprudential policies to minimize systemic risk in the financial markets are a relatively new phenomenon, and largely planned and implemented on the national level. The global implications are still to be worked out, as Stephen G. Cecchetti of the Brandeis International Business School and Paul M. W. Tucker of the Systemic Risk Council and a Fellow at Harvard’s Kennedy School of Government have shown. A truly stable global system requires a degree of financial regulation and coordination that current national governments are not willing to accept.

Exiting the Planet

Leave a reply

The full impact of President Trump’s announcement that the U.S. will withdraw from the Paris climate accord will not be fully realized for years, and indeed, decades to come. But the withdrawal is part of a series of disavowals of international agreements and commitments that were created after World War II. It represents a fundamental change away from engagement with allies and partners in the global community to a mindset sees every interaction with a foreign partner as a zero-sum situation, with only one country benefitting from the dealing.

The administration’s actions can be analyzed in the framework offered by Albert O. Hirschman’s in Exit, Voice and Loyalty. A member of an organization or an agreement that commits its members to a course of action, who is dissatisfied with the current arrangements, can decide whether to leave (“exit”), or remain and seek to correct the perceived problems. Those with more basic loyalty to the goals or principles of the existing arrangement are more likely to choose the latter option. Clearly the Trump administration does not share the loyalty to the international liberal order.

This position has its roots in U.S. history. The country initially sought to avoid involvement in World War I, and it took years of German offenses (such as the sinking of the Lusitania) before President Wilson could obtain agreement to enter the war. However, the Senate failed to approve U.S. membership in the League of Nations, and during the 1930s there was little interest in opposing German expansion in Europe or Japanese incursion in Asia. Only with the bombing of Pearl Harbor could President Roosevelt receive approval to take up arms against Japan, and Hitler’s declaration of war on the U.S. solved the problem of justifying a European conflict at the same time.

These experiences and the emergence of the U.S. as a global superpower after the war led to a fundamental change in the U.S. position. John Ruggie and others have described the rise of multilateralism, a system of international alliances and intergovernmental organizations formed under U.S. leadership for the purpose of achieving shared objectives. In many cases, these were  global public goods. The institutions ranged from the United Nations to the North Atlantic Treaty Organization, and more recently, the Paris Accord. While the fortunes of these organizations and pacts fluctuated over time, they contributed to international peace despite a half century of “cold war” between the Soviet Union and the U.S. They also facilitated the process of economic globalization that accelerated during the 1990s after the disintegration of the Soviet Union and the entry of China into the global economy.

All these organizations face challenges. The emerging market nations, for example, have sought a larger role within the IMF and the World Bank. NATO has grappled with redefining its mission in the post-Soviet world. But the success of all these efforts depends in large part on the involvement of the U.S. Agreements can be reached without U.S. participation But this country accounts for almost one-quarter of the global economy, and holds a commanding lead in terms of innovation. It will be difficult to organize a response to a global challenge without the involvement of the hegemonic country.

President Trump believes that he can achieve a better deal for the U.S. by negotiating with other countries on a bilateral basis. The results to date do not back this up (see also here). This does not mean that we can not do a better job of minimizing the disruptions that globalization entails. But devising a better safety net is primarily a domestic issue, and revising international accords is easier to achieve when there are gains for both sides.

More importantly, many of the key challenges we face—environmental, economic, defense—are not zero-sum issues. Cleaner air, a stable financial system or security in other nations do not threaten the U.S.; indeed, many of these are public goods that can not be obtained without international cooperation. Walking away from international agreements in a fit of nationalist pique only lowers the prospects of future peace and prosperity.

Crises and Coordination

Leave a reply

Policy coordination often receives the same type of response as St. Augustine gave chastity: “Lord, grant me chastity and continence, but not yet.” A new volume from the IMF, edited by Atish R. Ghosh and Mahvash S. Qureshi, includes the papers from a 2015 symposium devoted to this subject. Policymakers in an open economy who take each other’s actions into account should be able to reach higher levels of welfare than they would working in isolation.  But actually engaging in coordination turns out to be harder–and less common– than many may think.

Jeffrey Frankel of Harvard’s Kennedy School of Government uses game theory to illustrate the circumstances that hamper coordination. One factor may be a fundamental divergence in how different policymakers view a situation. Many analysts on this side of the Atlantic, for example, use the “locomotive game” to show that Germany should engage in expansionary fiscal policies that would raise output for all nations. But (most) German policymakers have different views of the external impact of deficit spending. In the case of the Eurozone, a deficit in one country increases the probability that it will need a bailout by the other members of the monetary union. Only rules such as those of the Stability and Growth Pact that limit deficit expenditures can eliminate the moral hazard that would otherwise lead to widespread defaults.

Charles Engel of the University of Wisconsin (working paper here) also examines the recent literature on central bank coordination. He points out that the identifying the source of shocks is necessary to assess the benefits of cooperation to address them, and suggests that financial sector shocks may be most relevant for modeling open-economy coordination. But widespread cooperation could undercut the ability of a central bank to credibly commit to a single target, such as an inflation target.

Policymakers in emerging markets who must deal with the consequences of policies in advanced economies have been particularly mindful of their spillover effects. Raghuram Rajan, for example, who is back at the University of Chicago after serving as head of India’s central bank, has urged the Federal Reserve and other central banks to take into account the impact that their policies have on other nations, particularly when unwinding their Quantitative Easing asset purchases. He pointed out: “Recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country.”

If international cooperation is viewed as a bargaining game, what incentives do the advanced economies have for cooperative behavior in light of the asymmetries among nations? Engel points out that in such circumstances, “…the emerging markets may believe that they have too little say in this implicit agreement, which is to say that they may perceives themselves as having too little weight in the bargaining game.” Conversely, central banks in the upper-income countries may in ordinary circumstances see little need to extend the scope of their decision-making outside their borders.

This attitude changes, however, when a crisis occurs, as Frederic Mishkin of Columbia shows in his examination of the response of central bankers to the global financial crisis. The Federal Reserve established swap lines to provide dollars to foreign central banks in countries where domestic banks faced a withdrawal of the funding they had used to acquire dollar-denominated assets. In addition, six central banks—the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank—announced a coordinated reduction of their policy rates. Coordination becomes quite relevant in a world of sudden stops and capital flight.

The need for such activities could increase if there is a global financial cycle, as Hélène Rey of the London Business School has stated. She presents evidence of the impact of global volatility, as measured by VIX, on international asset prices and capital flows. An important determinant of such volatility is monetary policy in the center countries. Rey agrees with Rajan that: “Central bankers of systemically important countries should pay more attention to their collective policy stance and its implications for the rest of the world.”

Perhaps a better motivation for the need for joint action comes from Charles Kindleberger’s list of the responsibilities that a hegemonic power such as Great Britain played in the period before World War I. These included acting as a lender of last resort during a financial crisis; indeed, it was the lack of such an international lender in the 1930s that Kindleberger believed was an important contributory factor to the Great Depression. Since the end of World War II the U.S. has vacillated in this role while the international monetary system has moved from crisis to crisis. Meanwhile, offshore credits denominated in dollars have grown in size, and could conceivably constrain the Federal Reserve’s ability to undertake purely domestic measures.

A policy of “America First” that means “America Only First and Last” ignores the fragility of the international financial system. Just as there are no atheists in foxholes, no one doubts the merits of coordination when there is a disruption of global markets. But suffering another crisis would be an expensive reminder that the best time to minimize systemic risk is before a crisis erupts.

The 2016 Globie: “Global Inequality”

Leave a reply

Each year I name a book as the “Globalization Book of the Year” (also known as the “Globie”). The selection is a recognition of its author’s contribution to our understanding of the causes and effects of globalization. There is no money attached to the prize—recognition is the sole reward. Recent winners can be found here and here.

This year’s awardee is Global Inequality by Branko Milanovic. The book has received a great deal of well-deserved attention for its analysis of how inequality has evolved in an era when goods, services and money—but not people—have been able to cross borders more easily than during any other period since the first era of globalization of 1870-1914. The returns from these transactions, Milanovic demonstrates, have been distributed in a very unequal fashion, which has changed the global distribution of income.

A graph of the gains in real per capita income over the periods of 1988-2008 (see here) shows that those at the bottom of the distribution of global income received some increases. But income rose more quickly for those in the middle percentiles, the 40th to the 60th. This group includes one-fifth of the world’s population, most of whom live in Asia, primarily China and India. Growth in those countries elevated their middle classes to become the world’s middle class. However, despite these advances these “winners” of globalization would still be considered poor by the standards of the upper-income countries.

The other group that recorded large gains during this period comprises the world’s richest people, the upper 1% whom Milanovic calls the “global plutocrats.” Their gains shrink if the data are extended to include the global financial crisis and its immediate aftermath. Nonetheless, this relatively small group benefitted enormously from the expansion of the global economy. While they are located around the world, one half of this group lives in the U.S.

The intervals of the income distribution space between the global middle class and the top 1% include the “lower middle class of the rich world” in Western Europe, North America, Oceania and Japan. They saw few gains during this period. Consequently, the benefits of globalization were skewed to those who knew how to benefit from it. Inequality as measured within countries increased in recent decades in the U.S. and other upper income countries.

What about the “Kuznets curve,” which predicts rising and then falling inequality in a country over time as it develops? Milanovic extends this concept to “Kuznets cycles” with alternating increases and decreases in inequality. Since the Industrial Revolution, wages have generally increased as income has grown in the advanced economies. But inequality also increased as the manufacturing sector with its higher wages attracted workers from the rural sectors. Inequality subsequently fell during the twentieth century  due to “benign forces,” which included increased education and government policies as well as “malign forces,” such as wars and civil conflict. That downswing ended sometime during the 1970s-1980s, and the upper income countries commenced on a new upswing that Milanovic attributes to a new technological revolution and globalization.

What does the future hold? Milanovic is careful in framing answers to that question, but emphasizes two main trends. The first is convergence, the diminution of the gap in income between poor and rich nations due to higher growth rates in the former as they catch up with the latter. If it continues, then global inequality will shrink. However, not all poor countries have recorded relatively higher growth rates, and African nations have recorded relatively lower growth rates. Overall, though, Milanovic judges that global convergence is more like to continue than to reverse.

The other trend to follow is inequality within countries. Milanovic writes that “…inequality in the United States is either still rising or is about to reach a peak of the second Kuznets wave.” The same pattern is found in other upper-income nations. How can these countries further the reversal of inequality? In the past inequality was lowered through government measures that included increased taxation and social transfers, as well as episodes of hyperinflation and wars. But increased taxes are harder to impose in a global environment. Milanovic, therefore, urges equalization in assets and in education. The former can be achieved through high inheritance taxes, corporate tax policies that distribute shares of ownership to workers, and tax and administrative policies that enable the poor and middle classes to hold financial assets. State-funded education is needed as well to equalize educational returns across all schools.

In the current political environment, however, elected officials seem more interested in reducing inequality by upending globalization. In the U.S., President-elect Trump has made renegotiating trade deals a top priority. Congressional representatives are looking at changes in the tax code that would encourage exports and discourage imports. The incoming Attorney General, Jeff Sessions, has hard-line views on migration. Moreover, the new Secretary of Education, Betsy DeVos, is an advocate of charter schools, not public schooling, while estate taxes may disappear as part of an overhaul of the tax system that will benefit the wealthy. In Europe, the government of Great Britain and officials of the European Union are preparing to negotiate the terms of Britain’s withdrawal from the EU.

Milanovic’s book provides a valuable perspective on inequality. It shows that there has been an historic turnaround  in inequality across national borders after a long period when Western countries kept drawing ahead of other nations. But inequality within many nations, including some emerging market economies, has risen. The challenge is to reverse the latter movement without offsetting the former. How countries deal with this challenge has become the dominant political issue of our time.

Milanovic ends his book by posing the question: “Will Inequality Disappear as Globalization Continues?” His answer: “No. The gains from globalization will not be equally distributed.” Milanovic deserves credit for putting that issue squarely on the global agenda.

The Electoral Consequences of Globalization

Leave a reply

The reasons for the election of Donald Trump as President of the U.S. will be analyzed and argued about for many years to come. Undoubtedly there are U.S.-specific factors that are relevant, such as racial divisions in voting patterns. But the election took place after the British vote to withdraw from the European Union and the rise to power of conservative politicians in continental Europe, so it is reasonable to ask whether globalization bears any responsibility.

The years before the global financial crisis were years of rapid economic globalization. Trade flows grew on average by 7% a year over the 1987-2007 period. Financial flows also expanded, particularly amongst the advanced economies. Global financial assets increased by 8% a year between 1990 and 2007. But all this activity was curtailed in 2008-09 when the global financial crisis pushed the world economy into a downturn. Are the subsequent rises in nationalist sentiment the product of these trends?

Trump seized upon some of the consequences of increased trade and investment to make the case that globalization was bad for the U.S. He had great success with his claim that international trade deals are responsible for a loss of jobs in the manufacturing sector. In addition, he blamed outward foreign direct investment (FDI) by U.S. firms that opened production facilities in foreign countries for moving manufacturing jobs outside the U.S. Among the firms that Trump criticized were Ford Motor, Nabisco and the Carrier Corporation, which is moving a manufacturing operation from Indiana to Mexico.

Have foreign workers taken the jobs of U.S. workers? Increased trade does lead to a reallocation of resources, as a country increases its output in those sectors where it has an advantage while cutting back production in other sectors. Resources should flow from the latter to the former, but in reality it can be difficult to switch employment across sectors. Daron Acemoglu and David Autor of MIT, David Dorn of the University of Zurich, Gordon Hanson of UC-San Diego and Brendan Price of MIT have found that import competition from China after 2000 contributed to reductions in U.S. manufacturing employment and weak U.S. job growth. They estimated manufacturing job losses due to Chinese competition of 2.0 – 2.4 million. Other studies find similar results for workers who do not have high school degrees.

Moreover, multinational firms do shift production across borders in response to lower wages, among other factors. Ann E. Harrison of UC-Berkeley and Margaret S. McMillan of Tufts University looked at the hiring practices of the foreign affiliates of U.S. firms during the period of 1977 to 1999. They found that lower wages in affiliate countries where the employees were substitutes for U.S. workers led to more employment in those countries but reductions in employment in the U.S. However, when employment across geographical locations is complementary for firms that do significantly different work at home and abroad, domestic and foreign employment rise and fall together.

Imports and foreign production, therefore, have had an impact on manufacturing employment in the U.S. But several caveats should be raised. First, as Erik Brynjolfsson and Andrew McAfee of MIT and others have pointed out, technology has had a much larger effect on jobs. The U.S. is the second largest global producer of manufactured goods, but these products are being made in plants that employ fewer workers than they did in the past. Many of the lost jobs simply do not exist any more. Second, the U.S. exports goods and services as well as purchases them. Among the manufactured goods that account for significant shares of U.S. exports are machines and engines, electronic equipment and aircraft. Third, there is inward FDI as well as outward, and the foreign-based firms hire U.S. workers. A 2013 Congressional Research Service study by James V. Jackson reported that by year-end 2011 foreign firms employed 6.1 million Americans, and 37% of this employment—2.3 million jobs—was in the manufacturing sector. More recent data shows that employment by the U.S. affiliates of multinational companies rose to 6.4 million in 2014. Mr. Trump will find himself in a difficult position if he threatens to shut down trade and investment with countries that both import from the U.S. and invest here.

The other form of globalization that drew Trump’s derision was immigration. Most of his ire focused on those who had entered the U.S. illegally. However, in a speech in Arizona he said that he would set up a commission that would roll back the number of legal migrants to “historic norms.”

The current number of immigrants (42 million) represents around 13% of the U.S. population, and 16% of the labor force. An increase in the number of foreign-born workers depresses the wages of some native-born workers, principally high-school dropouts, as well as other migrants who arrived earlier. But there are other, more significant reasons for the stagnation in working-class wages. In addition, a reduction in the number of migrant laborers would raise the ratio of young and retired people to workers—the dependency ratio—and endanger the financing of Social Security and Medicare. And by increasing the size of the U.S. economy, these workers induce expansions in investment expenditures and hiring in areas that are complementary.

The one form of globalization that Trump has not criticized, with the exception of outward FDI, is financial. This is a curious omission, as the crisis of 2008-09 arose from the financial implosion that followed the collapse of the housing bubble in the U.S. International financial flows exacerbated the magnitude of the crisis. But Trump has pledged to dismantle the Dodd-Frank legislation, which was enacted to implement financial regulatory reform and lower the probability of another crisis. While Trump has criticized China for undervaluing its currency in order to increase its exports to the U.S., most economists believe that the Chinese currency is no longer undervalued vis-à-vis the U.S. dollar.

Did globalization produce Trump, or lead to the circumstances that resulted in 46.7% of the electorate voting for him? A score sheet of the impact of globalization within the U.S. would record pluses and minuses. Among those who have benefitted are consumers who purchase items made abroad at cheaper prices, workers who produce export goods, and firms that hire migrants. Those who have been adversely affected include workers who no longer have manufacturing jobs and domestic workers who compete with migrants for low-paying jobs. Overall, most studies find evidence of positive net benefits from trade. Similarly, studies of the cost and benefits of immigration indicate that overall foreign workers make a positive contribution to the U.S. economy.

Other trends have exerted equal or greater consequences for our economic welfare. First, as pointed out above, advances in automation have had an enormous impact on the number and nature of jobs, and advances in artificial intelligence wii further change the nature of work. The launch of driverless cars and trucks, for example, will affect the economy in unforeseen ways, and more workers will lose their livelihoods. Second, income inequality has been on the increase in the U.S. and elsewhere for several decades. While those in the upper-income classes have benefitted most from increased trade and finance, inequality reflects many factors besides globalization.

Why, then, is globalization the focus of so much discontent? Trump had the insight that demonizing foreigners and U.S.-based multinationals would allow him to offer simple solutions—ripping up trade deals, strong-arming CEOs to relocate facilities—to complex problems. Moreover, it allows him to draw a line between his supporters and everyone else, with Trump as the one who will protect workers against the crafty foreigners and corrupt elite who conspire to steal American jobs. Blaming the foreign “other” is a well-trod route for those who aspire to power in times of economic and social upheaval.

Globalization, therefore, should not be held responsible for the election of Donald Trump and those in other countries who offer similar simplistic solutions to challenging trends. But globalization’s advocates did indirectly lead to his rise when they oversold the benefits of globalization and neglected the downside. Lower prices at Wal-Mart are scarce consolation to those who have lost their jobs. Moreover, the proponents of globalization failed to strengthen the safety networks and redistributive mechanisms that allow those who had to compete with foreign goods and workers to share in the broader benefits. Dani Rodrik of Harvard’s Kennedy School has described how the policy priorities were changed: “The new model of globalization stood priorities on their head, effectively putting democracy to work for the global economy, instead of the other way around. The elimination of barriers to trade and finance became an end in itself, rather than a means toward more fundamental economic and social goals.”

The battle over globalization is not finished, and there will be future opportunities to adapt it to benefit a wider section of society. The goal should be to place it within in a framework that allows a more egalitarian distribution of the benefits and payment of the costs. This is not a new task. After World War II, the Allied planners sought to revive international trade while allowing national governments to use their policy tools to foster full employment. Political scientist John Ruggie of the Kennedy School called the hybrid system based on fixed exchange rates, regulated capital accounts and government programs “embedded liberalism,” and it prevailed until it was swept aside by the wave of neoliberal policies in the 1980s and 1990s.

What would today’s version of “embedded liberalism” look like? In the financial sector, the pendulum has already swung back from unregulated capital flows and towards the use of capital control measures as part of macroprudential policies designed to address systemic risk in the financial sector. In addition, Thomas Piketty of the École des hautes etudes en sciences (EHESS) and associate chair at the Paris School of Economics, and author of Capital in the Twenty-first Century, has called for a new focus in discussions over the next stage of globalization: “…trade is a good thing, but fair and sustainable development also demands public services, infrastructure, health and education systems. In turn, these themselves demand fair taxation systems.”

The current political environment is not conducive toward the expansion of public goods. But it is unlikely that our new President’s policies will deliver on their promise to return to a past when U.S. workers could operate without concern for foreign competition or automation. We will certainly revisit these issues, and we need to redefine what a successful globalization looks like. And if we don’t? Thomas Piketty warns of the consequences of not enacting the necessary domestic policies and institutions: “If we fail to deliver these, Trumpism will prevail.”

The Impact of Financial Globalization on the Brexit Vote

Leave a reply

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

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

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

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

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

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

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

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

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

Leave a reply

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

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

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

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

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

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

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

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

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

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

The People’s Verdict on Globalization

1 Reply

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Inequalities, National and Global

Leave a reply

The publication of Thomas Piketty’s Capital in the Twenty-First Century brought attention to an issue that has been slowly seeping into public discourse. President Obama’s State of the Union address made it clear that we will not need to wait until the 2016 Presidential campaign to hear proposals to rectify the rise in inequality. But the data and trends of global inequality reveal a more complex situation than the national states of affairs that Piketty highlights.

Inequality is often measured by the Gini coefficient. This number is based on the Lorenz curve, which shows the proportion of the total income of a population that is cumulatively earned by different segments of the population, beginning at the bottom. The Gini coefficient (or index) is the ratio of the area under an actual Lorenz curve distribution of a society and the area of the distribution of perfect inequality. It is a number between zero and one (or 100), where zero corresponds to a case of perfect equality, and one is a situation of total inequality. A Gini coefficient above 0.50 is considered to be “high.”

We can compare Gini coefficients across countries and regions. Nations in Europe have Gini indixes between 0.24 and 0.36, while the comparable figure for the United States is 0.36. The coefficients are usually higher in middle- and lower-income nations; the average for Latin America and the Caribbean, for example, is 0.48, and for sub-Sahara Africa it is 0.44.

We can also look at how Gini coefficients change over time. What would we expect? The Kuznets curve, a concept based on the work of economist Simon Kuznets, predicts a rise in inequality within nations as they develop economically. The Gini coefficient would rise as workers move from low-productivity agricultural jobs to the industrial sector where wages are higher. But as a society matures and the agricultural sector shrinks, the gap between urban and rural workers should decline, and inequality fall.

The actual historical patterns, however, have been different. Inequality has been on the rise within many nations at high levels of inequality. Piketty claims that such inequality is a basic feature of capitalism, and will only worsen over time. His thesis is based on the relationship between the rate of return on capital, r, which includes profits, dividends, and interest, and the rate of economic growth, g. Piketty claims that when r > g, wealth accumulates quickly and the incomes of the richest members of society grows faster than those of the middle- and lower-classes.

This trend became strong in England, France and the U.S. in the 19th century. However, it was interrupted during the 20th century by the two World Wars and the Great Depression. Goverments intervened within their economies to improve the position of the poorest members, and the economic growth of the 1950s and 1960s reduced the importance of inherited wealth. But today, Piketty argues, we are returning to a world where economic growth is stagnating, and the rate of return on capital exceeds the economic growth rate. Unless governments intervene again, the result will be – and already has been – a return to the levels of inequality of the 19th century.

But there is another way of measuring inequality: not within nations but on a global basis. This has been done by, among others, economist Branko Milanovic. He points out that there are different ways of doing this. One method is to treat each country as a unit of observation, using the  average income of each nation. We can plot a Lorenz curve with all the countries for which there are data, and then calculate the corresponding Gini coefficients over time. If this method is used, there is little movement in the international Gini coefficient between 1960 and 1980. But during the period beginning in the 1980s through 2000, the international Gini coefficient rises. Richer countries grew faster than did the poorer ones, thus reinforcing inequality. This is the period when international trade and finance began to grow most quickly, and the observed trend would indicate that globalization rewarded the rich.

But if each country is treated as a single unit, we ignore the fact that some countries are much bigger than others. When countries are weighted by their population, a different phenomenon is observed: during the period that began in the 1980s, the international Gini coefficient falls, and has continued to do so over time. Why the difference? China and India had rapid economic growth during this period. Since they are countries with large populations, there was a decline in global inequality using population-weighted Gini coefficients during the period of increased globalization.

We can demonstrate this trend using a perspective that transcends national borders. Milanovic points out that If we arrange the world’s population by income regardless of national origin, we can calculate a global Gini coefficient. There are not many years of data available to do this calculation, but the trend that is observed shows that this global Gini coefficient has dropped.

Christoph Lakner and Milanovic showed this phenomenon another way, using global income data from 1988 to 2008. They calculated the rise in income for each decile of the world’s population. They observed the largest gains for the global top 1%, consistent with Piketty’s observations. But they also saw large gains for the the groups in the middle, most of whom were from Asia. This global perspective shows us that Piketty is correct in showing the growth in inequality within nations. But on a global basis there are some interesting movements across people in different nations.

Is there something about globalization itself that has led to these changes? There have many studies that compared the performance of countries that have opened their economies to international trade and finance with those that did not. Some of these studies also looked at the impact of globalization on the poorest members of society.

David Dollar and Aart Kraay, economists at the World Bank, compared the record of two groups of countries that they called globalizers and non-globalizers. The globalizers were those countries which had the largest growth in international trade between the 1970s and the late 1990s. They found that the globalizer nations grew more quickly than the non-globalizer nations. They also tested the effect of this economic growth upon the poor within these nations, and found that the increases in national income were reflected in increases for the poorest group. The authors concluded that open trade regimes lead to faster growth and poverty reduction in poor countries.

However, their conclusions have been challenged. One line of criticism has pointed out that openness to trade may be a result, not a cause, of rapid growth. Recent work on globalization and inequality shows a more complicated picture. A study by IMF economists Florence Jaumotte, Subir Lall and Chris Papageorgiou found that the rise in inequality within developed and developing countries is largely due to technological change, which primarily benefits those with education at the expense of those without education. These authors claimed that the impact of globalization on inequality has actually been relatively minor. Increased trade tends to reduce income inequality because of cheaper food imports, but more foreign investment leads to higher inequality because of the impact of foreign investment on the wages of skilled workers in both developing and developed countries: the more-educated workers gain while those less-educated fall behind. They concluded that the best remedy for increased inequality is more educational opportunities.

The situation we face today is complicated. On the one hand, inequality within nations has risen. On the other hand, inequality across borders may have fallen. Many are concerned that continued inequality might hinder growth. If those at the bottom of the income ladder do not participate in the benefits of globalization, then economic growth will be stunted. How to promote growth while ensuring that its benefits are shared by all is one of the most significant challenges facing nations today.

Tales of Globalization: Russia and China

Leave a reply

The end of 2014 marked the 23rd anniversary of the dissolution of the Soviet Union and the establishment of the Russian Federation. Like Chinese leaders in the previous decade, Russian policymakers faced the challenge of integrating their nation into the global economy. Russia’s trade openness (exports and imports scaled by GDP) grew from 26% in 1991 to 51% in 2013, very similar to the rise in China’s trade openness from 29% to 50% during these years. Russian exports increased from 13% of its GDP at the beginning of this period to 28% in 2013, while the corresponding figures for China are 16% and 26%. Both counties gradually allowed foreign capital inflows. But the similarities end there.

Russia’s exports are primarily commodities, particularly oil and natural gas. Consequently, sales of these resources account for a large part of Russia’s GDP: 16% in 2012. The plunge in world oil prices, combined with the sanctions imposed by U.S. and European Union governments following Russia’s annexation of the Crimea and its threats against the Ukraine, threaten to push the economy into a recession. The deterioration of the economic situation caused the ruble to plunge against the dollar in December, before recouping part of its value after the central bank intervened in the foreign exchange market and raised its policy rate to 17%.

Russia is particularly susceptible to a currency depreciation because of its external debt, reported to be $678 billion. Capital controls that had been imposed during the 1998 crisis were removed in the 2000s, and capital inflows, including bank loans and bond issues, increased significantly. These capital flows reversed during the global financial crisis, and there was only a modest recovery before the latest period of political tension. The Russian government’s debt includes $38 billion of bonds denominated in dollars, which is not seen as a vulnerability. But the external exposure of Russian companies is much larger. The Russian central bank claims that in 2015 Russian firms owe $120 billion of interest and repayments on their external debt. Much of this money is owed by Rosneft and Gazprom, the state oil and gas producers.

China has followed a very different path. Its main exports now include electronics and machinery. The Great Recession prompted a reevaluation of the structure of the economy by the Chinese government. Chinese leaders realize that the export- and investment-led growth of the past is no longer feasible or desirable, and have emphasized the expansion of domestic consumption. This transition is taking place while the economy slows from the torrid 10% growth rate of the past to about 7.5%.

China also has external debt, which totaled $863 billion in 2013. But China has been more deliberate in opening up its capital account, and its external liabilities primarily take the form of foreign direct investment. Moreover, its foreign exchange reserves of about $4 trillion should alleviate any concerns about its ability to fulfill its obligations to foreign lenders. Of more concern is the growth in domestic credit, which now surpasses 200% of its GDP. While a financial contraction appears inevitable, there are differences over whether this will lead to economic disruption (see also here).

China’s currency appreciated in value between 2005 and 2008, when the renminbi was “re-pegged” against the dollar. In March, the central bank announced that the renminbi would fluctuate within a band of +/- 2%. A recent study by Martin Kessler and Arvind Subramanian indicates that the renminbi is fairly valued by purchasing power estimates. The government is considering whether the renminbi will become an international currency. Its status may get a boost if the IMF decides to include the renminbi as one of the currencies on which its Special Drawing Rights is based.

China and Russia, therefore, have followed very different paths in globalizing their economies. Russia, of course, could not be expected to forsake its energy resources. But commodity exporters live and die by world prices, and the government passed up an opportunity to diversify the Russian economy. China initially used its own “natural resource” of abundant labor, but has moved up the value chain, as Japan and Korea did. Chinese firms are now expanding into foreign markets. In addition, Russia allowed short-term capital inflows that can easily cease, while China carefully controlled the external sources of finance.

Russia’s GDP per capita recorded a rise of 29% between 1991 and 2013, from $5,386 to $6,924 (constant 2005 US $). China started at a much lower base in 1991, $498, but its per capita income increased by over 7 times (719%) to $3,583. The divergence in the two countries’ fortunes shows that there are many ways to survive in the global economy, but some are more rewarding than others.