Tag Archives: U.S.

The Return of Global Imbalances?

The global economic contraction following the pandemic has led to a massive fiscal response. Governments have acknowledged the need to increase spending in order to offset the declines in consumption and investment. The decreases in public savings can lead to rising current account deficits that offset the capital inflows needed to cover the gap between savings and investment. But will these measures generate a return to the global imbalances that preceded the global financial crisis?

The IMF’s External Sector Report for 2020, subtitled Global Imbalances and the COVID-19 Crisis, appeared in August (see a summary here). The analysis was based on data from 2019, when the global current account imbalance (the absolute sum of all surpluses and deficits) fell by 0.2 of a percentage point to 2.9% of global GDP. But the report’s authors also considered the impact of the pandemic on countries’ balance of payments.

The IMF’s analysis suggested that about 40% of the 2019 current account positions were excessive. Larger than warranted surpluses were registered by Germany and the Netherlands, while deficits were larger than warranted in Canada, the U.K. and the U.S. China’s external position was in line with its fundamentals and policies.

In the report the IMF anticipated that in 2020 the U.S. would report a current account deficit equal to 0.5% of world GDP. Canada and the U.K.’s deficits were each projected to be equal in value to about 0.1% of global output. China was expected to register a surplus of about 0.2% of world GDP, as were Germany and Japan. These forecasts come with a large degree of uncertainty, and the report’s authors acknowledge that global financial stress could lead to more capital flow reversals and larger imbalances.

More recent data show clearly that the U.S. and China are running the largest current account imbalances in absolute terms. Brad Setser of the Council on Foreign Relations points out that Chinese firms have benefitted from the demand for electronic goods as workers stay at home, as well as the need for personal protective equipment. Moreover, the Chinese government has supported its firms that export, with less direct support for households. The U.S. has provided more direct support to households.

The fiscal responses of the two countries to the pandemic also differ. The Economist estimates that the 2020 U.S. budget balance will show a deficit equal to 15.3% of its GDP, while China’s deficit is estimated at 5.6% of GDP. Part of the U.S. fiscal deficit will be offset by household savings, which increased last spring to over 30% of disposable income. The savings rate has slowly come down since then, while households attempt to plan their spending in a world of uncertainty. If the recovery in the U.S. stalls and there is no additional fiscal stimulus, then households will be forced to dip into their savings.

The IMF’s current account forecasts are consistent with the analysis of  Matthew Klein and Michael Pettis in their recent book, Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace.  The authors claim that these imbalances reflect domestic policies that privilege the more affluent members of a country. The trade wars that divide nations reflect divisions within these countries between asset owners and workers.

Klein and Pettis attribute China’s surpluses, for example, to government decisions in the 1990s to foster development through investments and exports while suppressing Chinese consumption in order to generate savings. The government has since acknowledged this imbalance and sought to rebalance domestic spending, in part by promoting consumption expenditures while curbing shadow banking. But whenever economic growth has slowed, the government has responded by encouraging new investment, including housing, and total credit to the private sector has grown to 216% of GDP.

Similarly, Germany’s current account surpluses reflect its policies designed to encourage growth after the decade of the 1990s, when the costs of reunification weighed down the economy. There was a conscious decision to encourage savings, a shift that benefited capital owners at the expense of labor. Until this year the government took pride in its balanced budgets, despite a need for infrastructure spending. The high personal savings rate reflects in part a high degree of income inequality, with most gains going to those households more likely to save them. There was also an emphasis on the country’s external position, and wage increases were limited in order to hold down costs.

The increases in foreign savings were matched by capital flows to the U.S. These reflected the U.S. position as the financial hegemon, with the most liquid financial markets. Moreover, the U.S. provided something of great value: safe assets. U.S. Treasury bonds have been the preferred asset of central banks and European savers, although before the 2008-09 financial crisis mortgage backed securities with AAA ratings were seen as acceptable substitutes. The financial sector within the U.S. benefitted from the increase in domestic and foreign financial activity. But the capital inflows appreciated the dollar, which undermined the export sector. In the years leading up to the global financial crisis the Federal Reserve kept interest rates low in order to boost spending. A weak recovery after that crisis caused the Federal Reserve to continue its low interest rate policy.

The pandemic has brought a return to past conditions. Whether or not the most recent increase in the Chinese trade surplus is a transitory phenomenon, its current account is on track to record a surplus for the year (although at a much lower level than before the global financial crisis). Similarly, while Germany’s budget balance is forecast to show a deficit of 7.2% of its GDP for the year, its current account is expected to register a surplus equal in value to almost 6% of its GDP.  The U.S. current account deficit, which peaked at 6% of GDP in 2005, was equal in value to 3.5% of GDP in the second quarter of this year.

Klein and Pettis write that past global imbalances reflected a complementarity of interests between American financiers and Chinese and German industrialists, and reinforced inequality.  To change these patterns requires policy reorientations within these countries that will allow more income to be transferred to households. They admit that this is a difficult task, but point out that a new system was devised by the Allied nations at Bretton Woods in 1944 in order to guarantee living standards. The upheaval produced by the pandemic is global in nature and has the potential to bring about another policy transformation. The one necessary element that will be contested by those who profit from current arrangements is the political will.

The Challenges to the Dollar

The dollar’s position as the premier global currency has long seemed secure. The dollar accounts for about 60% of the foreign exchange reserves of central banks and similar proportions of international debt and loans. But recent developments raise the possibility of a transition to a stratified world economy in which the use of other currencies for regional trade and finance becomes more common.

Such a statement may seem to be inconsistent with the Federal Reserve’s activities to stabilize global financial markets. As it did during the global financial crisis of 2008-09, the Fed has activated currency swap lines with other central banks, including those of the Eurozone, Great Britain, Japan, Canada and Switzerland, as well as the monetary authorities of South Korea, Mexico and Singapore. Those central banks that do not have swap agreements can borrow dollars from the Fed via its new foreign and international monetary authorities (FIMA) facility. Under this program, central banks that need dollars for their domestic financial institutions exchange U.S. Treasury securities for dollars through a repurchase agreement. These moves accompany the Fed’s extensive range of activities to support the U.S. economy, which include cutting the federal funds rate to zero, purchasing large amounts of Treasury, mortgage backed and corporate securities, and lending to corporations and state and municipal governments.

But other governments are uneasy with the U.S. government’s use of the dollar’s position in international finance to enforce compliance with its foreign policy goals. International transactions in dollars are cleared through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) banking network and the Clearing House Interbank Payments System (CHIPS). The U.S. has denied foreign banks access to these systems when they wanted to penalize the banks for dealing with governments or companies that the U.S. seeks to punish. This practice has become more common under the Trump administration, which has used the sanctions to strike at Iran, North Korea, Russia, Venezuela and others.

European leaders have made clear that they find this use of the dollar’s international role no longer acceptable. When the U.S. abandoned the agreements on nuclear weapons with Iran, European banks were forced to choose between defying the U.S. or their own governments, which encouraged them to continue their ties with Iran. In response, Britain, France and Germany have founded a clearing house, Instex, to serve as an alternative system, and several other European Union members will join it. Moreover, if the Europeans proceed with the issuance of a common EU bond, there will be an alternative safe asset to U.S. Treasury bonds that will foster the use of the euro in foreign exchange reserves.

China is also moving to encourage the international acceptance of its currency as an alternative to the dollar. The Chinese bond market is the world’s second largest, and the foreign appetite for Chinese bonds has increased. Foreigners bought $60 billion of Chinese government bonds last year, and now hold 8.8% of these bonds. Some of these bonds will be held by central banks diversifying the composition of their foreign currency reserves.

China’s Belt and Road Initiatives have expanded its economic presence in emerging markets, which also leads to a wider usage of its currency. Chinese investments in infrastructure and other projects in these countries increase the usage of the renminbi, as will the trade that follows.  The number of banks processing payments in renminbi has grown greatly in recent years, and most of these banks are based in Asia, Africa and the Middle East.

There are obstacles to the wider use of both the euro and the renminbi. While Germany’s Chancellor Angela Merkel has voiced support of a common European bond, the heads of other European governments have expressed their concerns.  China continues to maintain capital controls, although it has allowed foreigners to invest in the bond market through Hong Kong. But the imposition of a new security law for Hong Kong raises concerns about China’s willingness to allow financial concerns to affect its political goals.

The euro was once more widely seen as a viable alternative to the dollar. Hiro Ito and Cesar Rodriguez of Portland State University in their recent research paper, “Clamoring for Greenbacks: Explaining the Resurgence of the U.S. Dollar in International Debt”, examine the determinants of the currency composition of international debt securities. In their analysis they undertake a counterfactual analysis to examine what would have happened to the shares of the dollar and the euro in the composition of these securities if the global financial crisis had not occurred. They report that the predicted share of the euro in international debt would have been higher than it actually has been, while the share of the dollar would be lower.

When Ito and Rodriguez wrote their paper, they forecast that the dollar would continue to be the dominant international currency. But the Trump administration has damaged the international standing of the U.S., and this will have long-term consequences. Benjamin J. Cohen of UC-Santa Barbara has pointed out that “…there is palpable resentment over Trump’s indiscriminate use of financial sanctions to punish countries…” More generally, the U.S. government has sought to limit the county’s international interactions.

Harold James of Princeton wrote about the dominance of the dollar after the global financial crisis in his book, The Creation and Destruction of Value: the Globalization Cycle, which was published in 2009. At that time he foresaw the central role of the dollar as continuing because of the “political and military might of the U.S.”, as well as its economic potential. But he also stated that:

 “Such concentrations of power can be self-sustaining when they attract not only the capital resources, but also the human resources (primarily through skilled immigration) that allow exceptional productivity growth to continue.”

James warned that if a country closes itself off from exchanges with other nations, its relative decline can be hastened. He pointed out that:

“Since the isolationist impulse is a major strand in the American political tradition, it is impossible to close off this possibility; in fact, its likelihood increases as the economic and political situation deteriorates.”

The pandemic has the potential of serving as an inflection point, which follows a period of confrontations with other countries over trade. The fumbled response of the U.S. to the pandemic will encourage the governments of Europe and China to extend their influence in the financial sphere.  A world with several dominant currencies need not be inferior to one with a single hegemonic currency. But it will come about in large part as a result of the self-inflected damage that the Trump administration has perpetrated on the international standing of the U.S.

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 2019 Globie: “Capitalism, Alone” by Branko Milanovic

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

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

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

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

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

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

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

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

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

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

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

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

2016    Branko Milanovic, Global Inequality

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

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

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

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.

The Rise and Fall of FDI

After the global financial crisis,  international capital flows contracted, especially bank lending in Europe. Foreign direct investment (FDI) by multinational firms, however, provided a steady source of external finance, particularly for emerging market economies. The McKinsey Global Institute has calculated that the global stock of FDI increased from 46% of world GDP in 2007 to 57% in 2016 ($25 trillion to $41 trillion). But FDI flows fell by 27% in 2018 according to the Organization of Economic Cooperation and Development (OECD), and this drop followed a decline of 16% in the previous year. We have entered a new period of contraction by multinational firms, and in particular, U.S.-based multinationals.

A significant amount of the decline is due to firms based in the U.S. responding to changes in U.S. tax law. The U.S.-based firms repatriated earnings that had been kept abroad to avoid U.S. taxes. As a result, the U.S. recorded a negative FDI outflow of $50 trillion in 2018, down from a positive outflow of $379 billion in the previous year. By the latter half 2018, the acquisition of foreign assets had returned to positive levels, but the long-run changes of the tax code revision on the foreign operations of U.S. firms will only become clear over time.

Ireland and Switzerland were particularly hard-hit by the disinvestments, since these countries had often attracted FDI because of generous tax provisions. There were also reversals of investment in Special Purpose Entities (SPE), which allow the multinationals to channel funds through countries with favorable regulatory and tax practices to their ultimate destination. The OECD reported that FDI flows to SPEs in Luxembourg and the Netherlands fell to negative levels last year.

But the alteration in U.S. tax law is only part of a wider change in policy in the U.S.  President Trump seeks to undo expansion by multinationals by persuading U.S. firms to return their operations to the U.S. During the last several decades, these firms and other multinationals used technological advances in communication and transportation to establish global supply chains of production. They located the production of intermediate goods in those countries where they were cheapest to produce before assembling them and exporting them to their final markets.

This expansion was facilitated by the establishment of stable macroeconomic and political conditions in the host countries where the production facilities were located. In many cases, these were emerging market nations, and their governments welcomed the investments of the multinationals, as the firms hired local labor and transferred capital and technology. Singapore, for example, has used its position as a financial hub and its reputation for pro-business regulatory policies to become a major recipient of FDI flows.

The establishment of production facilities in different countries has benefits and costs for home and host countries. But President Trump views this expansion only through the criterion of its impact on U.S. jobs, and he sees losses. He wants the U.S. firms to base their production in the U.S. where they will hire American workers. The President has frequently claimed that his use of tariffs and other tactics will re-establish manufacturing in the U.S.

Some U.S. firms were already responding to higher costs in China by shifting their supply chains elsewhere. But they often switch their operations to Vietnam and other low-wage countries, not the U.S. A policy of nationalism that forced firms to only operate here would require massive expenditures and higher costs for consumers. It would affect the ability of U.S. firms to export, since our exports often contain foreign components.

The Trump administration’s hostility to trade and outward FDI also affects inward FDI by foreign multinationals. These firms are often courted by state governments that want the high-paying jobs that they provide. Theodore H. Moran and Lindsay Oldenski of the Peterson Institute for International Economics and Georgetown’s School of Foreign Service have calculated that in 2013 the wages paid to the U.S. employees of foreign-owned multinationals exceeded those of U.S. workers of U.S. multinationals, which in turn exceeded those paid to workers in all firms by more than 10%. The U.S. and foreign multinationals accounted for 30 million workers, who in 2013 represented 22% of all jobs in the U.S.

But foreign firms have cut down on further expansion in the U.S.  Foreign capital inflows to the U.S. fell from $509 billion in 2015 to $267 billion in 2018. Some of this downturn may have been cyclical, but foreign firms also have to consider the effect of tariffs on U.S. production. Adam Posen of the Peterson Institute for International Economics has warned “…that this shift of corporate investment away from the U.S. will decrease long-term U.S. income growth, reduce the number of well-paid jobs available, and accelerate the shift of global commerce away from the U.S.”

The decline in FDI last year reflected other factors than U.S. policy measures. While 2018 initially was characterized as a period of widespread growth, this expansion slowed during the year in response to instability in Turkey and Argentina, credit tightening in China, and other developments. This global slowdown in growth is expected to persist and the IMF forecasts economic growth in 2019 of 3.3%, down from 3.6% in 2018.

There is evidence that the rapid pace of expansion of the pre-global crisis has come to an end. The return on equity of multinationals has fallen from its pre-crisis peak. The ability of firms such as Apple to continue to post continued growth in global sales is being questioned. Governments such as India’s seek to protect domestic firms from foreign competition. Moreover, as pointed out above, China no longer is a source of cheap labor, and firms need to adapt to changing cost structures.

The immediate impact of the change in the U.S. tax provisions on FDI has most likely ended. But the fall-off in corporate expansion over the last two years is also a response to the changes in international trade and finance. The Trump administration has made clear that it wants to reverse the globalization of recent years, and the imposition of tariffs on Chinese and other goods will lead to a reorientation of business models. Over time this may be seen as the last gasp of a reactionary regime that was reversed under a future president. But the President’s Democratic challengers seem equally reluctant to support trade and expansion by U.S. firms. Until the status of trade in the global economy is clarified, multinationals will be reluctant to commit to foreign expansion.

Searching for Stimulus

The global economy seems headed for a slowdown. The IMF now expects global growth this year of 3.3%, a drop of 0.2 of a percentage point from its previous forecast. Growth in the advanced economies is projected to be particularly feeble, with expected U.S. economic growth of 2.2%, growth of 1.3% predicted for the Eurozone , and Japan’s growth anticipated to be 1%. Of course, a breakdown of U.S.-China trade talks, the imposition of new U.S. tariffs on European cars or a disorderly Brexit could disrupt the forecasts. Can government policymakers improve these conditions?

Central banks have limited policy space. In the U.S., the Federal Reserve has made clear that it does not expect to raise the Federal Funds rate this year, and retains the option of lowering it if conditions deteriorate. Some–including one of President Trump’s anticipated nominees to the Board, Stephen Moore–are already calling for lower rates. But the current Federal Funds rate of 2.5% does not give the central bank much scope for lowering it.  Japan’s central bank already has negative nominal rate targets, while the European Central Bank’s policy rates include a lending rate of zero percent and a negative deposit facility return.

If monetary policy is constrained, what else can policymakers do? Adair Turner, former chair of the United Kingdom’s Financial Services Authority, believes that zero interest rates means that the time has come for “massive fiscal expansion” financed by central banks. He acknowledges that excessive monetary growth can be harmful. But, he argues, when faced with “slow growth, political discontent and large inherited debt burdens…”, policy measures that in other times would be seen as radical need to be considered.

Martin Wolf of the Financial Times is also concerned about the current low interest rates, which he attributes to secular stagnation. He believes that the low rates have created a disinflationary debt overhang, and calls for the use of fiscal policy to supplement private demand. Similarly, Mohammed El-Erian of Allianz points to Japan’s continued low growth as evidence of the limitations of monetary policy. He calls for looser government budgets that raise productivity through spending on education and infrastructure.

The recent record of increased deficits in the U.S. gives some guidance on the impact of a fiscal stimulus. Lower taxes did increase GDP growth in 2018, but the effect has faded and GDP is returning to its trend growth. Corporate taxes also declined, and as a result, the budget deficit widened. The Congressional Budget Office has forecast that the budget deficit will increase from 3.5% of GDP in 2017 to 5.4% in 2022, and the impact on the budget will persist.

The borrowing required to finance these deficits will reinforce the U.S. position, along with Japan and China, as one of the largest debtor nations. As in Japan, government debt represents a significant amount of U.S. total debt. The U.S. stands out, however, for increasing government debt during an expansionary phase of the business cycle when ordinarily debt shrinks. Other advanced economies have used this opportunity to lower their debt burdens.

Olivier Blanchard, former chief economist of the IMF, spoke about government borrowing at this year’s meetings of the American Economics Association. He pointed out that the ratio of debt to GDP need not rise as long as the growth rate of GDP exceeds the interest rate on government debt. That condition has been met since the 19th century  except during the decade of the 1980s. Moreover, the “crowding out” of private investment is less of a concern in a world of low interest rates.

There is one other aspect of fiscal expansion that should be considered: the impact on a country’s current account, and the impact on other countries. Menzie Chinn of the LaFolette School of Public Affairs at the University of Wisconsin and Hiro Ito of Portland State University have investigated the determinants of global imbalances. Using data from 24 industrial and 138 developing countries between 1972 and 2016, they report: “Fiscal factors determine imbalances, and have accounted for a noticeable share of the recent variation in imbalances, including in the U.S. and Germany.” In the group of industrial countries, a one percentage point increase in the deficit scaled by GDP leads to a 0.42% increase in the current account deficit, similarly scaled.  A significant part of the fiscal expansion, therefore, is transmitted to the rest of the world.

If advanced economies do share low growth rates and constrained monetary policies in common, then a coordinated fiscal expansion may be the best way of generating growth amongst them. But the record on fiscal coordination is, at best, mixed. All the members of the Group of Twenty enacted stimulus policies of different magnitudes during the global financial crisis. However, an earlier agreement in 1978 by Japan and Germany to enact expansionary fiscal measures while the U.S. decontrolled energy prices did not turn out so well. The German fiscal stimulus coincided with the second oil price shock of the decade, but the former was blamed for the subsequent increase in inflation. This experience confirmed German views of the futility of discretionary policies.

The chances, therefore, of a coordinated fiscal expansion among the advanced economies in the absence of another global shock are low. If this means that we do not have temporary surges in growth fueled by lower tax rates, then the long-run cost is low. But all the calls for fiscal policy cited above are for spending measures that would boost productivity. In the long-run, growth will only return if productivity increases, as it did in the 1990s in the U.S. In addition, any tax cuts should be designed to benefit those who have not shared in the gains of globalization. The largest increases in income in the U.S. have accrued to those in the upper tiers of the income distribution. Those below deserve a stimulus that actually benefits them.

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.