Globalization, Risks, and the Social Safety Net

In fact, it would be a fair summary of economic history to say that those nations that have opened their economies to the rest of the world have succeeded, and their populations prospered, while those nations that have failed to do so have been left behind.

This is true whether one looks back over the history of the last seven decades, since the end of the Second World War, or, more broadly, across the history of the last two centuries, since the beginning of the Industrial Revolution.

The formula for embracing globalization has remained stable at its core for the last 200 years: Those countries which have succeeded have…

  1. adopted new technologies,
  2. liberalized trade,
  3. allowed the inflow of foreign capital for investment, and
  4. opened themselves up to immigration.

Whether the discussion involves the US or Canada, Australia, or Western Europe, the countries that have followed the precepts above have tended to thrive over time, providing opportunity and high living standards for their citizens.

However, if we look to the rise of fascism in Europe during the 1930s, which led to the most destructive war that the world has ever known, the hallmarks of anti-globalization were very much ascendant: the statist, authoritarian, and xenophobic policies of governments turning inward.

In Europe during the 1930s, those causes set in motion in the political economy gave birth to their bleak counterparts in the financial economy: economic stagnation, deflation, and mass unemployment.

How Globalization Works

You can think of globalization in terms of trade in goods and services. Trade, broadly speaking, is beneficial because of what economists refer to as “comparative advantage.” What that technical economic term means is that you are really good at producing particular goods and services, and you can make certain goods more cheaply and efficiently than other countries.

By opening up to trade, especially in goods and services where you have comparative advantage, your market becomes the entire world. If you’re a small, open economy, like many countries in Europe, that freedom of trade becomes an economic lifeline. But even for a large, prosperous country like the United States, access to an international market means access to literally billions of potential customers.

The United States has a comparative advantage in more sectors than just the glamorous fields of Hollywood movies, music, and high tech—fields that people often think of as areas of American economic dominance. The US maintains comparative advantage in agricultural products, in advanced manufacturing, in financial services, and in other less visible business sectors.

On the import side of the equation, while people may argue that some imports displace jobs, firms, and income at home, the reality is that it doesn’t make economic sense to produce goods in the United States when it’s cheaper to produce those goods abroad.

If Chinese firms can produce, say, footwear for less money than we can domestically in the United States, it’s not useful to maintain production at home where it’s more expensive and less efficient. By creating trade policies that allow for the flexibility to manufacture footwear outside of the United States, US workers and firms can use their labor and capital to produce goods where they will add more value. (The globalization of services occurs in a similar fashion, when less profitable services are outsourced from the United States to China and other emerging market economies.)

Globalization can help to raise all boats in the global economy.

For advanced economies like the United States, it makes sense to export goods where we maintain a comparative advantage, while importing raw materials and services as inputs to the production process where we don’t enjoy a comparative advantage.

In such circumstances, globalization can help to raise all boats in the global economy.

Trade in Capital

We’ve talked about trade in goods and services, but now I would like to turn the topic to trade in capital. Trade in capital is the free movement of funds for investment in foreign markets.

On one side of the equation, firms can produce and invest abroad, which benefits workers and profits at home while increasing the power of domestic firms. An example would be an American high-tech company building a factory in China. This arrangement allows the American technology company to manufacture some of its goods more cheaply overseas and to increase its profits by benefiting from lower costs of production there. Those profits are then available for investment in other ventures, which may include, for example, domestic capital expenditure and domestic job creation.

On the other side of the equation, foreign firms can invest in factories and produce jobs in the United States. An example here would be a German automobile manufacturer building a plant in Tennessee or South Carolina. While the profits would accrue to the German parent company, the wages would accrue to American workers.

That’s what economists are referring to when they use the phrase Foreign Direct Investment, or FDI for short. FDI is something that is absolutely crucial to investors—large and small. When countries close their economies by imposing capital controls, the inflows of Foreign Direct Investment can suffer as a consequence.

Foreign Direct Investment is crucial to investors large and small.

There are multiple advantages to holding investments in foreign markets. International diversification helps protect investors from being overexposed to risks in their own domestic economies. For investors who live in advanced economies of the world like the United States, international diversification can potentially lead to the higher rates of return associated with markets that are growing at a much faster rate than economies in the developed world.

A Resurgence of Dark Forces

Despite the many benefits of globalized trade in goods and services, as well as foreign direct investment in Europe today, in the wake of the 100th anniversary of the First World War, some of the forces that led to the catastrophe of 1914 and again during the run-up to the Second World War appear to be experiencing a resurgence.

While the scope and intensity of the challenges now facing Europe may be but a faint shadow of what they once were, it must never be taken for granted that the terrible history of those dark decades won’t repeat itself.

The rising forces of anti-globalization in Europe are not confined to nations with a common history.

To cite just two examples, I recently visited The Netherlands, where the far right, Eurosceptic “Party for Freedom” gained parliamentary seats in a recent election. On the same trip, I visited Hungary, a former member of the Soviet-aligned Eastern Bloc, where, more ominously, the right-wing Fidesz Party won a controlling majority in 2010.

The circumstances that have given rise to the most recent round of statism in Hungary and The Netherlands are each unique to their culture, but the shared danger of turning inward and away from the world is the most salient theme in each case.

The verdict rendered by history demonstrates that attempts to protect domestic markets can limit some of the losses economies experience in the short term, at best; however, in the medium to long term, the costs far outweigh the benefits that protectionism confers.

Globalization: Not Without a Downside

It’s clear that authoritarian governments overplay the risks of globalization to suit their own domestic political agendas, but globalization is not without its downsides. In a globalized world, filled with rapid technological innovation, some firms will rise while others will disappear; in fact, with the current rate of technological change and innovation, entire industries can disappear with astonishing speed.

In addition to the challenges posed by the creative destruction of capitalism, even the staunchest supporters of free trade realize globalization cannot make all individuals in an economy better off at the same rate. While these distributional effects are not unique to globalization, globalization can unmask them and seem to exacerbate their impact on an economy.

Social welfare benefits do not reduce the incentives to work, move, or retrain workers.

Instead of fighting the forces of globalization, I would suggest that a successful policy prescription should focus on how to create an economy that thrives within the context of a globalized world. While globalization does not create the risk of losing your job, under certain circumstances it may exacerbate or hasten the inevitable creative destruction of capitalism. Under such circumstances, proper policy prescriptions are required to help cushion the blow of the globalized markets.

In my view, one of the paradoxes of globalization is that those who are most in favor of globalized free markets are often the least supportive of the social safety nets that are required for globalization to be a success.

The right types of social safety nets, in my experience, are those that support capitalism and embrace risk and mobility. To help make labor markets more flexible and individuals more accepting of the realities of globalization, governments must help buffer the risks of the inherent frictions within capitalism.

  • First, workers need to be able to count on reasonable unemployment benefits.
  • Second, they need to be able to maintain healthcare packages at a reasonable cost.
  • Third, there must be opportunities for education.
  • Fourth, there must be money available to retrain workers to gain the skills they need to compete in new sectors.
  • And finally, there needs to be pension benefits to assist workers who are forced to retire early due to bad luck in the labor market.

It’s often assumed that social welfare benefits reduce the incentives to work, move, or retrain workers—but, in fact, the opposite is true.

Understandably, individuals become less likely to invest a small fortune educating themselves in new skills when they fear a revolution in technology or a shock to trade could wipe them out entirely.

The truth is that bad luck can hit any of us over the course of a lifetime. Because of that uncertainty, some form of social safety net is required to make labor markets more flexible, to allow more mobility of people, of regions, and of resources.

In the long run, the best way to guard against the risks inherent in a globalized economy is to invest in social capital through education. From the beginning, competitive societies must provide economic opportunity to as broad a cross-section of people as possible. The best way to ensure that is to provide ourselves, our children, and our grandchildren with the educations that allow them to thrive in a world in which, increasingly, comparative advantage accrues to those who have more skill, whether they are blue-collar or white-collar workers.

In the long term, everyone benefits from trade liberalization because of the benefits of open markets—countries open their markets to more foreign goods, foreign markets open to them in turn.

In developed-market economies, the benefits are twofold. Not only are more foreign goods exported but average consumers benefit from decreased costs of goods and services. This is especially true for consumers at the lowest end of the income scale, who will find the most relief in buying high-quality, inexpensive, foreign goods.

Benefits of Globalization

The benefits of globalization are not limited to cheaper goods. In the case of developing nations, foreign direct investment can bring with it not only financial capital but also the managerial skills and technologies required to make a nation more competitive.

In the case of China, part of China’s economic success has been their openness to foreign direct investment, and their ability to absorb, or occasionally copy, the technologies that benefit their manufacturing base.

Perhaps the most compelling examples of globalization success are the cases of nations divided or politically partitioned.

At the conclusion of the Korean War in the early 1950s, Korea was left formally divided into North Korea and South Korea. At the time of the partition, North Korea was more industrialized than South Korea.

Now, after 60 years of shutting itself out from all interaction with the world—avoiding trade, technology, and investment—North Korea has become quite literally a hell on earth. A nation starving, with over six million people in dire need of food aid, while South Korea is now the third-largest economy in Asia.

In both cases, the culture, background, traditions, and history are the same. The crucial difference is the power of an idea that embracing technology, free trade, and open labor markets can change the course of a nation’s economic and political future.

Understanding the Globalized World We Live In

The world, increasingly, exists in a state of interdependence.

What happens in China, Europe, and the Middle East—economically, politically, and socially—affects the lives of everyone in a globalized and interdependent world. (To pick an obvious and sobering economic example, take the numerous ways in which the geopolitics of the Middle East are intertwined with the energy markets—as the oil shocks of 1973, 1979, and 1990 clearly demonstrate.)

No individual, company, or nation is an island. What happens in the world affects you—and what you do affects the world.

Decisions individuals make over the course of a lifetime—education, choice of profession or occupation, how to save, and where to invest—depend very much upon how they view the interdependence of the world.