Re-thinking the flat world

We need to understand the differences between trade and financial globalisation

February 22, 2011

In popular discussion, both proponents and opponents of economic globalisation tend to see it as an ‘all or nothing’ package, implying that there must be either uniform liberalisation across flows of goods, services, labour and finance – or uniform restriction. Certainly, because cross-border integration in different matters stems from the same basic factors, it tends to be correlated across them. The ultimate drivers of globalisation are technological – improvements in communication and transportation that ‘make the world smaller.’ As a consequence, aspects of the economy have tended to globalise in parallel.

But policy and politics can make a difference; they can bring about variations in the degree of integration across different sectors of the economy. Capital markets, for instance, were highly integrated before 1914 (using the telegraph and mail as means of communication); less integrated from 1914 to the 1970s because of war and interventionist policies, and more integrated since as deregulationism took hold. Likewise, comparing across geographies, we see that China today permits flows of goods to cross its borders but imposes tight restrictions on capital flows – clearly a different situation from the more uniformly liberalised West. Australia, meanwhile, restricts labour flows but is open to goods, services and capital. Globalisation, in other words, is not an all or nothing package and we can look separately at the merits of integration for different aspects of the economy.

Integration of markets in goods and non-financial services – free trade – seems largely beneficial, especially for small countries. It permits access to resources not available at home. It increases the variety of goods and services available. It transmits ideas and binds nations together. And it allows countries to specialise in particular goods and services, achieving economies of scale and clustering.

There are drawbacks to free trade, but these are either outweighed by its advantages or can be addressed relatively easily. For example, very poor countries may lose a nascent industrial base, vital to their development, if they are suddenly hammered by foreign competition – but this can be addressed through gradualism in the process of integration, measures to support exports (such as an undervalued currency) and efforts to import capital and expertise into domestic firms. Poor countries that are dependent on exporting primary commodities may be exposed to volatility and corruption – but these can be dealt with by efforts to develop manufacturing and other sectors and, if governments are disciplined, through a national fund to buffer the impact of commodity price swings.

Likewise, international competition may effectively transfer wages from manual workers in developed countries to those in poor ones – but it must be right that workers in poor countries get a fairer share and any excess inequality generated in rich societies can be addressed through a mixture of redistribution, up-skilling and a focus on advanced industries. Finally, trade integration, by increasing complexity, may make it harder for central banks to see what is coming, hindering their efforts at stabilisation – but the increase in complexity is not so great and it is the complexity of finance that is the real issue.

Evidence shows that opening to trade usually boosts trend rates of GDP growth, with cumulative additions to GDP of up to 15-20 percent occurring over several decades in smaller countries, and up to seven to 10 percent in large ones. The impoverishment of small countries that close themselves off from the world proves the same point.

Integration in labour markets, meanwhile, allows the poor of the world to join developed economies, where they have more opportunities. It also permits firms to find the best staff regardless of nationality and permits growing industries in any country access to skills that may be scarce at home but are abundant elsewhere. On the other hand, labour market integration can deprive poor countries of skilled workers and put pressure on essential services in rich countries when the influx of users outnumbers the influx of people to provide such services – a situation that will take at least a generation to unwind itself. Worker migration can also cause tension when divergent cultures and religions are brought together. It seems clear that moderate regulation must be imposed on migration between countries that diverge economically and that measures to facilitate cultural assimilation are needed.

Finance, as usual, presents the most complex challenges. Cross-border investment is clearly necessary – countries that are small or poor can develop a lot faster if they receive inflows of foreign capital to establish new industries. When one sees FDI by multinationals bringing new activities, new skills and higher-paying jobs to previously impoverished places, it is hard to see it as anything but good. There are problems: big businesses sometimes engage in abusive behaviour in weak legal jurisdictions; behavioural economists have found evidence that managers tend to be less kind when workers are of a different nationality; foreign executives may have less concern for the national interest than domestic ones. But emerging economies are still better with multinationals than without.

The case for short-term investment in shares, bonds and other financial instruments freely crossing national borders is less clear-cut. Analysis from the IMF shows no increase whatsoever in trend rates of GDP growth following capital account liberalisation. Meanwhile, over the past 30 years, volumes traded in currency exchange markets, quantities of funds crossing national borders daily and the balance sheets of financial institutions have all grown many times faster than GDP, while trend rates of GDP growth themselves have barely shifted – showing that all this extra activity is adding little to the real world.

This doesn’t mean that flows of portfolio capital have no value. Deep financial markets make it easier for firms to raise capital and reduce the risk that actions by a few investors will inappropriately distort the pricing of financial instruments. It may be just that these services were adequately provided by capital markets as they existed in, say, 1980 – and that further integration has added nothing.

Financial globalisation also has undesirable consequences. Allocating millions of workers to finance prevents from them doing other things. Ownership of firms by remote and short-termist shareholders harms long-term business development. Flows of hot money into and out of small or emerging economies tend to compound the pattern of bubble and bust inherent in markets – sometimes culminating in currency collapses that decimate the ability of domestic firms to meet foreign obligations and purchase supplies, leading to mass unemployment.

Volatile capital flows can disrupt trade by moving exchange rates irrationally. And financiers riding asset price bubbles and taking the premium in a hugely increased volume of trading creates unnecessary inequality and its attendant social ills.

Foreign ownership of government bonds may also put governments under pressure to shrink their role in the economy and may reduce their ability to engage in fiscal stimulus during recessions. Similarly, firms and fund managers may put capital into nations where they share the ideologies of the leadership and take it away from more interventionist states. There is thus some danger of a ‘race to the bottom,’ whereby progressive nations are starved of capital and forced to change direction. This cannot happen when capital is bottled up in the domestic economy.

In reality, however, the problem has not materialised to anything like the extent feared. A great deal of capital is not internationally mobile and an interventionist state creates advantages for business in terms of skills, infrastructure and stability that prevent much of the mobile capital from fleeing to low-tax jurisdictions. Workers have a strong affinity for their home economy and labour flows are even less likely than capital flows to be the agent of a race to the bottom.

Nevertheless, aside from FDI, a high degree of integration in capital markets is of questionable utility. We couldn’t revert integration to 1980 levels without causing chaos. But moderate controls – such as a low tax on foreign exchange transactions, or time delays on capital withdrawals from a jurisdiction (with the duration of the delay based on amount), would be helpful. With appropriate financial and legal infrastructure to prevent speculators disguising capital flows as trade flows to get them through, such measures can work.

The need for exchange controls becomes clearer when we appreciate a difficult constraint that applies to international exchange. Countries can only have two of three out of a) free cross-border capital flows, b) ability to use monetary policy to regulate the domestic economy and c) ability to stabilise their exchange rate. If they try to use monetary policy to manage both the exchange rate and domestic conditions when capital can easily cross their borders, then whenever they need to move monetary conditions in opposite directions to meet internal and exchange rate targets, the two goals will cut against one another. Thus, since the ability to manage domestic demand is valuable, and since arbitrary exchange rate fluctuations are undesirable while highly liberalised capital flows do little good, it makes sense to sacrifice some of the latter in order to dampen currency volatility.

There are two lessons in all this. One is that global integration, making use of the full resources of the world to achieve economic goals, is common sense; but delivers on its potential only in the context of a well-regulated economy. The other is that we should encourage trade globalisation more than the financial kind.