Tag Archives: Europe

Is There a Future for FDI?—Update

The Organization of Economic Cooperation and Development (OECD), which recently reported on foreign direct investment (FDI) in 2019, has released a new study on the impact of the pandemic on future FDI. The OECD points out notes that FDI flows before the pandemic have been on a downward trend since 2015, and FDI flows in 2018 and 2019 were lower than any years since 2010, suggesting that the decline in FDI will not be reversed when the pandemic eases. This comes as policymakers in the U.S. and elsewhere show concern over Chinese acquisition of domestic firms, and the Chinese government clamps down on Hong Kong’s autonomy.

The OECD report’s authors have optimistic, middle and pessimistic scenarios on the effectiveness of public health and economic policy measures, and their impact on FDI flows in the medium term. Under the optimistic scenario, public health measures are effective in controlling the spread of the virus and economic policies successful in restoring economic growth in the latter half of this year. FDI flows would fall between 30% to 40% in 2020 before rising by a similar amount in 2021 to their previous level. Under the middle scenario, public health and economic policy measures are partially but not completely effective, and FDI flows fall between 35% to 45% this year before recovering somewhat in 2021, but would remain about one-third below pre-crisis levels.  The pessimistic scenario is based on the need for continued measures to contain the virus and repair extensive economic damage, which would lead to drop in FDI flows of over 40% this year and no recovery in 2021.

The impact of an extended decline in FDI will be particularly severe for emerging market and developing economies, which have already seen the reversal of portfolio capital flows. The OECD report points out that the primary and manufacturing sectors, which account for a large proportion of FDI in these economies, have been particularly hard hit during the pandemic. Moreover, the corporate earnings that are a major source of the funding of new FDI expenditures by multinational firms fell in 2019 and will decline further this year.

The decline in FDI will be significant for these economies. FDI flows are usually more stable than other forms of capital flows, but even FDI collapses when it by global turbulence. The parent companies often have the financial resources to assist affiliates in troubled economies, but no advanced economy is escaping the downturn. The decline in spending not only affects the employees in the host country, but also harms domestic suppliers and others who benefit from the activities of the multinational.

The pandemic is also motivating governments to monitor and restrict the acquisition of domestic firms. Several U.S. Senators have urged Treasury Secretary Steven Mnuchin to limit the purchase of U.S. firms with depressed stock prices by Chinese firms. The U.S. has already limited Chinese acquisition of domestic firms in critical sectors, and that will now most likely be expanded to include medical goods and services. Portfolio investment is also under scrutiny. The U.S. Senate has passed a bill that requires foreign companies to allow their records to be audited by the Public Company Accounting Oversight Board in order to sell stock or bonds in the U.S., and the House of Representatives is considering a similar bill. While the bill will affect all foreign firms, it clearly is aimed at Chinese firms.

The U.S. is not alone in acting to restrict foreign investment. Several European countries have mechanisms to review foreign investment in order to protect critical technologies, as do India and Australia. These will now be extended to include medical goods and services. The European Union’s competition chief, Margrethe Vestager, has urged the governments of the EU’s members to purchase shares of ownership stakes in companies in order to prevent foreign takeovers.

FDI to China is also likely to suffer from the Chinese government’s enactment of a new security law for Hong Kong. U.S. Secretary of State George Pompeo’s response that the U.S. will no longer consider Hong Kong to have significant autonomy will not only imperil Hong Kong’s status as an international banking center, but also its role as the major source of FDI for China. The Chinese government’s willingness to forsake that source of funding suggests that it no longer believes that FDI has a critical role to play in the country’s economic development.

FDI, then, faces a range of barriers. The pandemic puts multinational plans for expansion, already scaled back, on hold. The division into a world of competing U.S. and Chinese spheres of influence further reduces the scope of foreign investment. Potential host nations can only hope to be viewed as a feasible site for production by multinationals once the world economy revives.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Mars Descending? U.S. Security Alliances and the International Status of the Dollar

A decade after the global financial crisis, the dollar continues to maintain its status as the chief international currency. Possible alternatives such as the euro or renminbi lack the broad financial markets that the U.S. possesses, and in the case of China the financial openness that allows foreign investors to enter and exit at will. Any change in the dollar’s predominance, therefore, will likely occur in response to geopolitical factors.

Linda S. Goldberg and Robert Lerman of the Federal Reserve Bank of New York provide an update on the dollar’s various roles. The dollar remains the dominant reserve currency, with a 63% share of global foreign exchange reserves, and serves as the anchor currency for about 65% of those countries with fixed exchange rates. The dollar is also widely utilized for private international transactions. It is used for the invoicing of 40% of the imports of countries other than the U.S., and about half of all cross-border bank claims are denominated in dollars.

This wide use of the dollar gives the U.S. government the ability to fund an increasing debt burden at relatively low interest rates. Moreover, as pointed out by the New York Times, the Trump administration can enforce its sanctions on countries such as Iran and Venezuela because global banks cannot function without access to dollars. While European leaders resent this dependence, they have yet to evolve a financial system that could serve as a viable alternative.

The dollar’s continued predominance may also reflect other factors. Barry Eichengreen of UC-Berkeley and Arnaud J. Mehl and Livia Chitu of the European Central Bank have examined the effect of geopolitical factors—the “Mars hypothesis”—versus pecuniary factors—the “Mercury hypothesis”—in determining the currency composition of the international reserves of 19 countries during the period of 1890-1913. Official reserves during this time could be held in the form of British sterling, French francs, German marks, U.S. dollars and Dutch guilders.

The authors find evidence that both sets of factors played roles. For example, a military alliance between a reserve issuing country and one that held reserves would boost the share of the currency of the reserve issuer by almost 30% if there was a military alliance between these nations. They conjecture that the reserve issuer may have used security guarantees to obtain financing from the security-dependent nation, or to serve the role of financial center when the allied country needed to borrow internationally.

Eichengreen, Mehl and Chitu then use their parameter estimates to measure by how much the dollar share of the international reserves of nations that currently have security arrangements with the U.S. would fall if such arrangements no longer existed. South Korea, for example, currently holds 84% of its foreign reserves in dollars; this share would fall to 54% in the absence of its security alliance with the U.S. Similarly, the dollar component of German foreign exchange reserves would decline from 98% to 68%.

In previous eras, such calculations might be seen as interesting only for providing counterfactuals. But the Trump administration seems intent on cutting back on America’s foreign military commitments. The U.S. and Korea, for example, have not negotiated a renewal of the Special Measures Agreement to finance the placement of U.S. troops in Korea.  German Chancellor Angela Merkel has defended her country’s role in NATO in the face of criticism from President Trump that Germany must spend more on defense expenditures. The possibility of a pan-European army to serve as an alternative security guarantee is no longer seen as totally far-fetched.

The dollar may be safe from replacement on economic grounds. But the imminent shrinkage of the British financial sector due to the United Kingdom’s withdrawal from the European Union  shows that political decisions follow their own logic, sometimes without regard for the economic consequences. If the dollar lose some of its dominance, it may be because of self-inflicted wounds.

The 2018 Globie: “Crashed”

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

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

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

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

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

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

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

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

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

Previous Globie Winners:

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

2016    Branko Milanovic, Global Inequality

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

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


The Continuing Dominance of the Dollar

Ten years after the global financial crisis, we are still coming to an understanding of how profound a shock it was. The changes in political alignments within and across nations and the diminished public support for globalization continue. But one aspect of the financial system has not changed: the dominance of the U.S. dollar in the monetary system.

An article by Fernando Eguren Martin, Mayukh Mukhopadhyay and Carlos van Hombeeck of the Bank of England in the BOE’s Quarterly Bulletin documents the different international roles of the dollar. First, it continues to be the main currency in central bank reserves, with a share of about 70% of total holdings. Second, the dollar is used as an invoicing currency for many international transactions, such as commodity sales. Third, firms outside the U.S. obtain funding through dollar-denominated bank loans and debts.

The use of the dollar for finance has also been examined by Iñaki Aldasoro and Torsten Ehlers of the Bank for International Settlements in an article in the BIS Quarterly Review. They report a rise in the use of international debt securities, driven primarily by dollar denominated debt issued by non-U.S. residents. The increase in such funding is particularly noticeable in emerging markets economies in Asia and Latin America. This debt includes sovereign bonds issued by governments that sought to lock in low interest rates.

What about the alternatives? A report on the international role of the euro issued by the European Central Bank acknowledges the primacy of the dollar. An index of the global status of the euro developed at the ECB shows a decline in the last fifteen years, which may have stabilized in the most recent year. This includes a fall in the euro’s share of international debt securities. The report also notes that the deleveraging of Eurozone banks as they built up their capital ratios led these banks to reduce their cross-border lending.

Why does the dollar continue to possess a hegemonic status a decade after the crisis that seemed to signal an end to U.S.-U.K. dominated finance? Gillian Tett of the Financial Times offers several reasons. The first is the global reach of U.S. based banks. U.S. banks are seen as stable, particularly when compared to European banks. Any listing of the largest international banks will be dominated by Chinese banks, and these institutions have expanded their international business.  But the Chinese banks will conduct business in dollars when necessary. Tett’s second reason is the relative strength of the U.S. economy, which grew at a 4.1% pace in the second quarter. The third reason is the liquidity and credibility of U.S. financial markets, which are superior to those of any rivals.

The U.S. benefits from its financial dominance in several ways. Jeff Sachs of Columbia University points out that the cost of financing government deficits is lower due to the acceptance of U.S. Treasury securities as “riskless assets.” U.S. banks and other institutions earn profits on their foreign operations. In addition, the use of our banking network for international transactions provides the U.S. government with a powerful foreign policy tool in the form of sanctions that exclude foreign individuals, firms or governments from this network.

There are risks to the system with this dependence. As U.S. interest rates continue to rise, loans that seemed reasonable before now become harder to finance. The burden of dollar-denominated debt also increases as the dollar appreciates. These developments exacerbate the repercussions of policy mistakes in Argentina and Turkey, but also affect other countries as well.

The IMF in its latest Global Financial Stability (see also here) identifies another potential destabilizing feature of the current system. The IMF reports that the U.S. dollar balance sheets of non-U.S. banks show a reliance on short-term or wholesale funding. This reliance leaves the banks vulnerable to a liquidity freeze. The IMF is particularly concerned about the use of foreign exchange swaps, as swap markets can be quite volatile. While central banks have stablished their own network of swap lines, these have been criticized.

The status of the dollar as the primary international currency is not welcomed by foreign governments. The Russian government, for example, is seeking to use other currencies for its international commerce. China and Turkey have offered some support, but China is invested in promoting the use of its own currency. In addition, Russia’s dependence on its oil exports will keep it tied to the dollar.

But interest in formulating a new international payments system has now spread outside of Russia and China. Germany’s Foreign Minister Heiko Maas has called for the establishment of “U.S. independent payment channels” that would allow European firms to continue to deal with Iran despite the U.S. sanctions on that country. Chinese electronic payments systems are being used in Europe and the U.S. The dollar may not be replaced, but it may have to share its role as an international currency with other forms of payment if foreign nations calculate that the benefits of a new system outweigh its cost. Until now that calculation has always favored the dollar, but the reassessment of globalization initiated by the Trump administration may have lead to unexpected consequences.

Economic Consequences of Populism

Who is the true populist: Bernie Sanders, who promises single-payer health care and college without tuition, or Donald Trump, who campaigned on a promise to “drain the swamp”?  Jeremy Corbyn of the UK’s Labour Party, who wants to nationalize public-sector firms, or Marine Le Pen of France’s National Front, who wants to take France out of the Eurozone? And what would be the consequences of their policies?

To answer these questions requires first an understanding of populism. One definition of populism, such as the one found here, refers to it as policies for the “common people.” Populism, therefore, divides the world into two groups: the good “common people” and the evil “them.” “They” deprive the “people” of the rewards of their hard work and exclude them from the political process. But just who are these “common people”? And who are not?

Dani Rodrik of Harvard’s Kennedy School in one recent paper and a second coauthored with Sharun Mukand of the University of Warwick proposes an analytical framework for understanding the different strands of nationalism. Rodrik and Mukand suggest that populist politicians obtain support by exploiting divisions within a society, and envisage two kinds of separation. The first is an ethno-national split, such as occurred in Europe in the 1930s and again in modern-day Europe, and is usually associated with right-wing movements. The second is a partition by economic class, as seen in the U.S. in the 1890s, Peron’s Argentina and contemporary Venezuela, and is often found in left-wing organizations.

Under this classification, Trump and Le Pen are nationalist populists while Sanders and Corbyn have a class-based agenda. Once we understand this demarcation, we can see they will advocate different policies. The nationalist populists are suspicious of all foreign contact. They regard trade pacts as zero-sum transactions: one side to an agreement wins, and the other loses. Similarly, immigrants hurt native workers and impose fiscal costs on society. These populists are in favor of government expenditures for the “people,” but not anyone else. They favor domestic firms and will support measures to benefit them.

Class-based populists, on the other hand, are concerned about the “workers,” who includeindustrial laborers and farmers. They are suspicious of property owners and the financial sector. They seek to use taxes and other measures to redistribute property. They may also advocate government control of the economy through public ownership or the use of licenses and other means to guide production. They can grant subsidies for the purchase of basic needs, such as food or fuel. They will oppose foreigners if they are seen as allied with domestic financiers.

Initially, populist measures of either type may lead to prosperity, as more domestic and/or government spending leads to more jobs. But less efficient firms are subsidized, which increases costs. Over time these costs must be paid, as well as those made directly to households. If the bond markets are reluctant to finance government budget deficits (except at very high interest rates), the government may turn to the central bank to finance its expenditures. But the resulting inflation leads to more spending and monetary creation. A country with a fixed exchange rate, like several in Latin America, eventually runs out of foreign exchange. The resulting crises are blamed on “foreigners” or “capitalists,” and eventually may lead to a collapse.

Rudiger Dornbusch and Sebastian Edwards (currently at UCLA’s Andersen School of Management) wrote an analysis of the populist policies of Latin American governments that appeared in the Journal of Development Economics in 1990 (see working paper here). In their view:

“We mean by “populism” an approach to economics that emphasizes growth and income redistribution and deemphasizes the risks of inflation and deficit finance, external constraints and the reaction of economic agents to aggressive non-market policies.…populist policies do ultimately fail; and when they fail it is always at a frightening cost to the very groups who were supposed to be favored.”

The most prominent manifestations of President Trump’s nationalist populism have come in the negotiations over NAFTA  and the administration’s refusal to abide by the decisions of the World Trade Organization. In addition, there are its policies that affect illegal immigrants and its support of measures to cut legal migration. None of these will lead to an immediate crisis in the U.S.  economy, but they will have long-run consequences for the growth of the economy. Moreover, the law of unintended consequences has a wide reach, The Trump administration may find that retaliation can sting.


The Impact of Financial Globalization on the Brexit Vote

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.

Greece’s Missing Drivers of Growth

Analyses and discussions of Greece’s economic situation usually begin—and often end—with its fiscal policy. The policies mandated by the “troika” of the European Commission, the European Central Bank and the International Monetary Fund have undoubtedly resulted in a severe contraction that will continue for at least this year. But little has been said about the private sectors of the economy, and why they have not offset at least part of the fiscal “austerity.” Consumption spending is linked to income, so there is no relief there. But what about the other sources of spending, investment and net exports?

Investment expenditures provide no counterweight, as they have plunged in the years since the global financial crisis. The same phenomenon took place in other countries in the southern periphery of the European Union, but the change in Greece’s investment/GDP ratio between its pre-crisis 2007 level and that of 2014 was an extraordinary decline of 16 percentage points at a time when GDP itself was falling:

Investment/GDP 2007 2014
Cyprus 24% 12%
Greece 27% 11%
Ireland 28% 17%
Italy 22% 17%
Portugal 23% 15%
Spain 31% 19%

Source: IMF, World Economic Outlook

In view of the scale of the crisis, it is not surprising that investment fell as much as it did in these countries. The parlous state of the banks only reinforced the decline. The particularly severe decrease in Greece reflects the political uncertainty there as well as the calamitous economic conditions.

Net exports of goods and services have continued to record a deficit in Greece while the other periphery countries by 2013 showed small (or in the case of Ireland large) surpluses:

Balance on goodsand services/GDP 2007 2013
Cyprus -5% 2%
Greece -12% -3%
Ireland 9% 21%
Italy 0% 2%
Portugal -8% 1%
Spain -6% 3%

Source: World Bank, World Development Indicators

Although Greece’s balance continued to show a deficit, the turnaround between 2007 and 2013 of 9 percentage points of GDP was only exceeded by the increase in Ireland’s trade balance by 12 percentage points. But this change was due largely to the decline in imports that accompanied the contraction of the economy rather than a growth in exports, as happened in Ireland and Portugal. The lack of Greek export growth has been surprising in view of the decline in unit labor costs. These had soared in the period leading up to the crisis, as had those in the other periphery countries. Since these countries could not devalue their exchange rates, labor costs had to come down to make their exports competitive. But despite the declines in wages, there has been no corresponding expansion in Greek exports.

Explaining the lack of responsiveness of Greek exports to the decline in wages has been the subject of several analyses. A study on macroeconomic adjustment programs in the Eurozone undertaken for the Economic and Monetary Affairs Committee of the European Parliament by a team of authors that included Daniel Gros, Cinzia Alcidi and Alessandro Giovannini of the Centre for European Policy Studies, Ansgar Belke of the University of Duisberg-Essen, and Leonor Coutinho of the Europrism Research Centre claimed: “Greek exports price competitiveness has not improved nearly as much as its cost (and wage) competitiveness…” The report’s authors attribute the rigidity in prices to “structural deficiencies.”

A similar analysis was offered by Uwe Böwer, Vasiliki Michou and Christph Ungerer of the European Commission’s Directorate-General for Economic and Financial Affairs (see also here). They use a gravity model to predict export flows in 56 countries, and compare the predictions of the model with actual exports. Greek exports were 32.6% lower than those predicted by the model, which they label the “puzzle of the missing Greek trade.” They then add measures of institutional quality to their model, and find that these are quite significant. Since Greece’s institutional quality is seen as relatively poor, the authors claim this deficiency contributes to the lack of exports.

In view of all the institutional measures that have already been introduced into the Greek economy, it may seem surprising that more structural reform is seen as necessary. Alessio Terzi of Bruegel has argued that the initial reforms in Greece were slanted towards reform of the public sector rather than the private sector. Some of this shortfall was rectified in the 2012 program, but implementation was slowed by the political climate and economic collapse. A lack of coordination with changes in labor market practices has resulted in a decline in wages that has not been matched by corresponding adjustments in prices. Terzo claims that responsibility for these flaws in program design is a responsibility of the troika as well as of the Greek government.

Designing the optimal composition and pace of structural reforms is always difficult. Antionio Fatás of INSEAD writes about the record of reform in Europe since the 1970s (see also here). He shows that there has been a convergence of policies and institutions over time. He takes particular note of Greece and Portugal’s progress vis-à-vis the record of other OECD countries in business-related reforms, although he also notes that small differences are associated with noticeable differences in productivity and output. Christian Thimann of the Paris School of Economics and AXA Group believes that there is substantial scope for further change.

Can reforms be implemented when fiscal policy is contractionary? Tamim Bayoumi of the IMF admits that the short-run impact of regulatory changes is likely to be disruptive, which only reinforces the impact of the fiscal policy. Under these circumstances, the IMF can play a critical role in providing external financing while reforms are being implemented. But, he writes, “…structural policies need a strong leader and broad agreement across a wide swath of opinion makers about the need to re invigorate the economy.”

Such an agreement is difficult to achieve in the wake of a crisis. Atif Mian of Princeton, Amir Sufi of the Booth School of Business at the University of Chicago and Francesco Trebbi of the Vancouver School of Economics have shown that countries become more polarized after a financial crisis as voters become more ideologically extreme and ruling coalitions become weaker. This makes consensus much harder to achieve.

The latest bailout provides an opportunity to change the structure of Greece’s private sector. Consumer markets are to be liberalized, labor practices to be reviewed and an upgrade of its infrastructure to be taken. Can Prime Minister Alexis Tsipras maintain the popular support needed to implement the reforms? And can these lead to a turnaround in the Greek economy? The private sector must become viable if the country’s continuing economic degradation is to end. It would be ironic if such a turnaround occurred during the administration of a political leader who campaigned on a platform of defying the troika and its programs, including structural reform measures. But “a foolish consistency is the hobglobin of little minds, adored by little statesmen and philosophers and divines…”


Greek Tale(s)

No matter what new twist the Greek debt crisis takes, there can be no question that it has been a catastrophe for that country and for the entire Eurozone. The Greek economy contracted by over a quarter during the period of 2007 to 2013, the largest decline of any advanced economy since 1950. The Greek unemployment rate last year was 26.5%, and its youth unemployment rate of 52.4% was matched only by Spain’s. But who is responsible for these conditions depends very much on which perspective you take.

From a macroeconomic viewpoint, the Greek saga is one of austere budget polices imposed on the Greek government by the “troika” of the International Monetary Fund, the European Commission and the European Central Bank in an attempt to collect payment on the government’s debt. The first program, enacted in 2010 in response to Greece’s escalating budget deficits, called for fiscal consolidation to be achieved through cuts in government spending and higher taxes. The improvement in the primary budget position (which excludes interest payments) between 2010-11 was 8% of GDP, above its target. But real GDP, which was expected to drop between 2009 and 2012 by 5.5%, actually declined by 17%. The debt/GDP level, which was supposed to fall to about 155% by 2013, actually rose to 170% because of the severity of the contraction in output. The IMF subsequently published a report criticizing its participation in the 2010 program, including overly optimistic macroeconomic assumptions.

To address the continuing rise in the debt ratio, a new adjustment program was inaugurated in 2012, which included a writedown of Greek debt by 75%. Further cuts in public spending were to be made, as well as improvements in tax collection. But economic conditions continued to deteriorate, which hindered the country’s ability to meet the fiscal goals. The Greek economy began to expand in 2014, and registered growth for the year of 0.8%. The public’s disenchantment with the country’s economic and political status, however, turned it against the usual ruling parties. The left-wing Syriza party took the lead position in the parliamentary elections held this past January, and the new Prime Minister, Alexis Tsipras, pledged to undo the policies of the troika. He and Finance Minister Yanis Varoufakis have been negotiating with the IMF, the ECB and the other member governments of the Eurozone in an attempt to obtain more debt reduction in return for implementing new adjustment measures.

The macroeconomic record, therefore, seems to support the position of those who view the Greek situation as one of imposed austerity to force payment of debt incurred in the past. Because of the continuing declines in GDP, the improvement in the debt/GDP ratio has remained an elusive (if not unattainable) goal. (For detailed comments on the impact of the macroeconomic policies undertaken in the 2010 and 2012 programs see Krugman here and Wren-Lewis here.)

Another perspective, however, brings an additional dimension to the analysis. From a public finance point of view, the successive Greek governments have been unable and/or unwilling to deal with budget positions—and in particular expenditures through the pension system—that are unsustainable. Pension expenditures as a proportion of GDP have been relatively high when compared to other European countries, and under the pre-2010 system were projected to reach almost 25% of GDP by 2050.  Workers were able to receive full benefits after 35 years of contributions, rather than 40 as in most other countries. Those in “strenuous occupations,” which were broadly defined, could retire after 25 years with full benefits.  The amount that a retiree received was based on the last year of salary rather than career earnings, and there were extra monthly payments at Christmas and Easter. The administration of the system, split among over 100 agencies, was a bureaucratic nightmare.

Much of this has been changed. The minimum retirement age has been raised, the number of years needed for full benefits is now 40, and the calculation of benefits changed so as to be less generous. But some fear that the changes have not been sufficient, particularly if older workers are “sheltered” from the changes.

Moreover, government pensions are important to a wide number of people. The old-age dependency ratio is around 30%, one of the highest in Europe. The contraction in the Greek economy means that the pension is sometimes the sole income payment received by a family. It is hardly surprising, therefore, that the pension system is seen as a “red line” which can not be crossed any further in Greece.

The challenge, therefore, is for the government to establish its finances on a sound footing without further damaging the fragile economy. This will call for some compromises on both sides. The IMF’s Olivier Blanchard has called for the Greek government “to offer truly credible measures“ to attain the targets for the budget, while showing its commitment to a limited set of reforms, particularly with pensions. But he also asks the European creditors to offer debt relief, either through rescheduling or a further “haircut.” Other proposals have been made (see here) that also attempt to satisfy the need to restructure the government’s finances while offering the Greek people a way to escape their suffering. There may be a strategy that allows Greece to reestablish itself on a new financial footing. But if the European governments insist that Greece must also pay back all its outstanding debt, then there is only one possible ending for this saga, and it will not be a happy one.

To fix or not to fix: Jeffry Frieden’s “Currency Politics”

The decision by the Swiss National Bank to abandon its peg to the euro serves as an example of the relatively limited life spans of fixed exchange rate regimes. While the fragility of exchange rate commitments has been known since the publication of a 1995 paper by Obstfeld and Rogoff, the question of why some central banks fix the value of their currencies and others do not is less well understood. Jeffry Frieden’s Currency Politics provides a thoughtful guide to the political economy of exchange rate policy.

Frieden, the Stanfield Professor of International Peace at Harvard’s Department of Government, analyzes the decisions on the choice of exchange rate regime and also the level of the exchange rate. There is rarely a consensus within a country on these issues, and the position of the domestic parties depends on how they are affected by fluctuations in the exchange rate. The principal supporters of a fixed rate will be those who are exposed to substantial foreign exchange rate risk in their global activities, such as financial institutions and multinational corporations. Those who have borrowed in a foreign currency will also have a stake in keeping the domestic value of their debt fixed. Producers of tradable goods tied largely to world prices, such as commodities and standardized manufactured goods, will favor a depreciated exchange rate, as will those who use nontradable goods as inputs. While decisions over the choice of regime and the level of a currency’s value are conceptually separate, Frieden writes that the politics usually lead to a split between those who favor a fixed rate versus those who seek a depreciation.

Frieden tests these hypotheses with data from a range of historical experiences: the U.S. from the Civil War through the end of the 20th century, Europe during the period from the end of the Bretton Woods regime to the introduction of the euro, and Latin America from 1970 to 2010. He uses both qualitative and quantitative analysis in these sections of the book, and his use of data from the earlier periods is particularly skillful. The results show that a consideration of exchange rate-related issues sheds light on the divisions that exist over policies, and can lead to revised views of accepted versions of history.

In the case of the U.S., for example, Frieden breaks the post-Civil War era into the 1862-79 period, when the U.S. returned to the gold standard, and the period of 1880-96, when the gold standard came under attack from the Populist movement. In the first era, those business and financial interests who were most exposed to currency volatility sought to resume the linkage to gold that had been broken in order to finance the Civil War. They were opposed by tradable good producers, including many (but not all) manufacturers, farmers and miners. After 1873, the political divisions centered on whether the U.S. would go on a bimetallic standard of gold and silver, or base the dollar solely on gold. Frieden uses Congressional voting patterns to test whether economic divisions were reflected in Congressional voting on measures related to currency policy. The results generally confirm the influence of the interests he suggests were governing factors. For example, Congressional districts from New England and Pennsylvania, which included manufacturers who competed with foreign producers, were more likely to oppose measures that would return the U.S. to the gold standard. Similarly, representatives of farm products that were exported also opposed a return to gold, while other farming districts tended to support it.

The return of the U.S. to the gold standard in 1879 did not end the dispute. Falling agricultural prices prompted farmers to agitate for a bimetallic regime that would lead to a devaluation of the dollar. Miners concentrated in the Rocky Mountains also supported the use of silver. Manufacturers, on the other hand, abandoned the anti-gold movement as they were protected by high tariffs.  Frieden’s empirical analysis of votes on monetary measures between 1892-95 shows that debt, which has often been viewed as the source of farmers’ concerns, did not sway representatives to vote against gold; indeed, the districts with the largest debt levels were pro-gold. But representatives of export-oriented farm districts were more likely to vote against the gold standard. The People’s Party (the “Populists”) united the farmers, miners and other groups in supporting a bimetallic standard, and in 1896 joined the Democratic Party in supporting William Jennings Bryant for President. Bryant’s loss, followed by a second loss in 1900, signaled the end of organized opposition to the gold standard.

Frieden undertakes similar analyses of depreciation and variation in European exchange rates between 1973-94 and reports evidence supporting the argument that producers exposed to currency risk favored stability, while tradable producers preferred flexibility. Similarly, an analysis of the determinants of Latin American choices of exchange rate regime between 1960 and 2010 finds that the more open economies favor fixed exchange rates. However, manufacturers in the more open economies preferred flexibility.

Frieden convincingly demonstrates, therefore, that exchange rate policy is governed by distributional concerns. Different interests take opposing sides over whether a fixed or flexible regime will be chosen, and whether it will be used as a policy tool to favor domestic producers. The relative influence of the competing interest groups can change over time.  An increase in trade or financial openness, for example, can lead to a new alignment of parties.

Can these considerations be applied to the Swiss case? The dropping of the currency peg discomforted both those who favored a fixed rate and those who will be adversely affected by the subsequent appreciation. But the Swiss central bank must be concerned about the impact of the European Central Bank’s policy of quantitative easing, which would require further intervention and the accumulation of more foreign exchange. The Swiss move may be more of a tactical maneuver during a volatile period than a strategic change in policy. However, those Swiss firms who will see their profits from foreign sales plummet will not be quiescent about the new regime.