Commentators often assume that relatively unfettered trade in goods and services and free movement of capital are givens, but the drive toward greater economic openness could now be undergoing a reversal, with profound implications for the global economy. This piece, the first of a two-part series, looks at the drivers of this shift.
Globalization reached its zenith in the late twentieth and early twenty-first centuries. This rise of international trade and free movement of capital facilitated a period of unprecedented growth and prosperity.
But as English statesman Lord Palmerston noted: “nations have no permanent friends or allies, they only have permanent interests.” In the aftermath of the global financial crisis, these interests dictate a reversal of the trend toward greater global integration and a return to autarky.
In economics, autarky refers to a closed economy with limited international trade or capital flows.
The Austro-Hungarian Empire, Japan during the Edo period, Nazi Germany and Italy under Benito Mussolini all pursued national policies favoring autarky. More recently, countries as varied as the Soviet Union, Afghanistan (under the Taliban), Cambodia (under the Khmer Rouge) and Myanmar, until recently, operated as closed economies. Today, the world is implicitly embracing Juche, North Korea’s autarky-focused state ideology.
Unprecedented economic and financial pressures are behind this shift toward closed economies. This coming economic war may reshape the world order in unexpected ways.
The post-Second World War period saw remarkable expansion in global trade and capital flows. The collapse of the Berlin Wall and re-integration of China, Russia and Eastern European into the world economy provided impetus for globalization.
Consumption and production were unbundled, expanding over time into the division of manufacture itself. As each stage of production was undertaken in the most efficient location, businesses and nations rapidly embraced a transnational system of production.
Deregulation allowed globalization of capital. Savings in one part of the world sought attractive and profitable investment opportunities in another. Investment and risk management instruments facilitated this Monetary Diaspora.
Globalization was a product of its times. In a virtuous cycle, it both created and relied on strong economic growth. Individual nations sacrificed national interest as benefits of integration outweighed costs.
Prosperity discouraged inquiry into the drivers and assumptions behind the drive toward global integration, burying its essential fragility.
Less Gain, More Pain
Enlightened self-interest underpinned the system, as long as it delivered prosperity for most nations. For many nations, following the global financial crisis, the advantages of greater economic and monetary integration are now less obvious. A self-reinforcing combination of economic, political and social factors is now driving a shift towards closed economies.
Economic growth overall has slowed and is likely to be tepid for an extended period. For many nations, the reduced direct benefits of global trade and capital dictate a withdrawal to more closed economies. By closing their economies and focusing domestically, nations believe that they can capture a greater share of available growth and deliver greater prosperity for their citizens.
The forecast distribution of future growth also influences this shift. Less affected by the crisis, for emerging nations, the benefits of participation in the global economic system, which previously assisted improvements in their living standards, are now diminished. Less affected by the crisis, they are wary of having to pay for the problems of many developed countries.
The crisis also highlighted the composition of income and wealth which underlay globalization.
In manufacturing, profits in the value chain require control of essential intellectual property rather than production. The majority of profits from Apple’s iPhones, made in and recorded as part of China’s exports, comes from high-tech components, intellectual property and branding which are captured by non-Chinese firms.
Developed nations and businesses control vital logistics and supply chains for vital trade. They dominate international financial activities, generating substantial earnings from financing trade and managing investments.
When growth rates were high, the unbalanced distribution of benefits of globalization was tolerated, albeit grudgingly. But lower growth rates and decreased benefits may lead nations to seek to maximise their own position at the expense of others, reducing the degree of engagement in a global economic system.
Links in the Chain
In an economically integrated world, supply chains for goods and vital commodities are international rather than national. This makes them sensitive to changes in cost structures, currency values and transportation costs.
International supply chains are also vulnerable to disruption from climatic or environmental factors. The Japanese tsunami and Thai floods of 2011 highlighted the vulnerability of supply chains, when shortages of minor but essential components halted production elsewhere. These disasters also highlighted the threat to secure access to essential resources such as oil, water and food.
There is now increased recognition that specialization leaves national and regional economies vulnerable to competitive pressure from other nations or localities or dislocations in supply chains. These factors may also drive a reversal of globalization and a shift to more closed economies.
Economic and political sovereignty is undermined by globalization. The financial crisis revealed that integration reduces the effectiveness of a nation’s economic policies, unless other nations take co-ordinated action.
Governments reacted to the global financial crisis by initiating large government spending programs to support the economy. In many cases, there was significant financial leakage, with spending boosting imports rather than promoting domestic demand, employment, income and investment.
Changes in tax policy can be rendered ineffective if other countries do not follow suit.
The problems are greater for global issues requiring internationally co-ordinated policies, such as climate change and better management of scarce non-renewable resources. Emerging nations are unwilling to accept initiatives that would impinge on their growth and policy flexibility. They argue that the problems are the result of past poor practices and resource management by developed nations for which they should not have to pay the price.
This also implicitly encourages pursuance of strategies that favour national objectives at the expense of other countries. International agreements on global issues which require self-sacrifice on the part of nations become difficult.
Autarky or closed economies is a natural way to deal with these pressures, reasserting sovereign control. As one nation adopts such policies, it compels other countries to pursue similar strategies to protect its own interests.
Various breakdowns—restrictions on trade, currency manipulation, capital controls and predatory regulations—now signal the retrenchment of globalization and return to autarky.
Despite oft-repeated statements at G-20 meetings about the importance of free trade and avoiding the mistakes of the 1930s, trade restrictions are increasing. The motivation is protection of national industries, iconic businesses, employment, incomes and competitive advantage.
Subsidies, government procurement policies favouring national suppliers, “buy local” campaigns, preferential financing and industry assistance policies are used to direct demand. Safety and environmental standards are used to prevent foreign products penetrating national markets.
Direct intervention, artificially low interest rates and quantitative easing are deliberate policies to manipulate currencies. Devaluation makes exports more competitive assisting individual countries to capture a greater share of global trade, boosting growth. Devaluation is also used to reduce real debt levels by reducing the purchasing power of foreign investors holding a nation’s debt.
But such actions invite destructive retaliation in the form of tit-for-tat currency wars. In February 2013, Chile’s Finance Minister writing in the Financial Times warned that “by seeking relief at the expense of other economies, [quantitative easing] is, in its essence, a globally counterproductive policy”. The process is also ultimately self-defeating as not every country can have the cheapest currency.
Free movement of capital has become increasingly restricted. Since 2008, the growth in cross border capital flows have slowed with global financial assets increasing by just 1.9% annually, well below the 7.9% average growth from 1990 to 2007.
Governments have resorted to financial repression, a process designed to channel funds to governments to help liquidate otherwise unsustainable debts or prop up financial institutions and economic activity.
Nations with high levels of government debt that face financing difficulties seek to limit capital outflows. These would prevent depositors and investors withdrawing funds to avoid potential losses from sovereign defaults or in Europe a breakdown in the common currency and redenomination of investments into a domestic currency. In Cyprus, explicit capital controls designed to prevent capital flight were implemented.
Low interest rates and weak currencies in developed economies have led capital to flow into emerging nations, with higher rates and stronger growth prospects. Volatile, short term capital inflows threaten to destabilise economies, by driving up the value of currencies and creating inflationary pressures. Brazil, South Korea and Switzerland have implemented controls on capital inflows.
Currency volatility also affects economic development in other ways. Devaluation of the US dollar drives up the price of commodities, such as food and energy which are denominated in the American currency. In poorer countries where spending on food and energy, including everyday essentials like cooking oil, is a high proportion of income, this causes hardship.
Higher commodity prices in combination with large flows of capital create inflationary pressures in many countries which force authorities to increase interest rates that slow economic growth. These developments threaten to reverse progress in reducing poverty.
These pressures have meant that the movement of capital has become increasingly restricted. In a significant reversal of its historical policy, the IMF has accepted the use of “targeted, transparent, and generally temporary” direct controls to limit volatile cross-border capital flows.
Thieves Falling Out
Nations are increasingly using regulatory initiatives to gain advantage.
In the aftermath of the financial crisis, developed nations worked together to strengthen regulation of financial institutions. The proposals are intended to be adopted internationally, ensuring consistency and a level playing field.
Stringent regulations of multinational financial institutions, active in complex financial products, may not be appropriate for countries with less developed financial systems. Under the guise of regulations needed to strengthen the financial system, the US has implemented measures whose extra-territorial application may give American banks a business advantage.
Emerging nations especially argue that adoption of these proposals would impede the ability of local banks to provide credit necessary to support local economies. It would also pose significant compliance costs and erode their competitive position. They are increasingly sceptical about accepting such regulatory standards.
These differences may lead to the lack of uniform financial regulation, resulting in a balkanised global financial system.
In 2013, the European Union proposed a financial transactions tax which would be collected by the Euro-Zone’s biggest economies but would be applicable to trades in all the world’s main financial centres. The objective was to raise revenue, with the secondary objective of reining in speculative trading. But it was the extra-territorial reach of the proposal that was interesting.
The proposal revealed divisions within Europe. The UK opposed to the tax as it would affect its economically important financial services centre in London. The US also opposed the tax, expressing determination to ensure that even if implemented it did not extend outside the Euro-Zone or affect legitimate activity outside of their borders. The UK and the US sought to protect their large and globally important financial services firms, just as the European proposal sought, indirectly, to reduce their influence.
All of these steps impede free movement of capital, one of the hallmarks of globalization.
Drift Toward Closed Economies
Evidence of the end of globalization and greater integration is mounting. Growth in trade and cross-border investment which has underpinned prosperity and development is being reversed.
Despite the economic benefits of global trade, a retreat to autarky and policies that favor closed economies is now a serious possibility with far-reaching consequences.
© 2013 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money.