The 2016 Globie: “Global Inequality”

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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

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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 Retreat of Financial Globalization?

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

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

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

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

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

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

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

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

Capital Flows and Financial Crises

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

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

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

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

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

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

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

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

The Search for an Effective Macro Policy

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

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

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

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

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

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

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

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

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

 

Capital Flows and Financial Activity in Commodity Exporters

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

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

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

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

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

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

The Impact of Financial Globalization on the Brexit Vote

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

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

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

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

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

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

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

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

Conferences

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

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

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

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

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

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

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

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

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