EC120 Spring 2015: Week 25, Topic 20, Slide 1

EC120: The World Economy in Historical Perspective

Topics Week 25: The Present and Future (?) in Light of the Past • 1. The changing character of globalization during the 20 century. 1a. Trade in goods. 1b. Factors promoting closer international integration in goods

production. 1c. Trade in services. 1d. Financial integration. 1e. Possible explanations for changes over the 20th century. • 2. Globalization and financial crises. 2a. Definitions. 2b. Summary overview. 2c. The build-up of debt since 1970. • 3. The outlook after the crash.

EC120 Spring 2015: Week 25, Topic 20, Slide 2

EC120: The World Economy in Historical Perspective 1. The changing character of globalization during the 20 century. • The global economy at the beginning of the 21st century looked more

like it had at the beginning of the 20th than in most of the years in between.

• So how different is the current phase of growing international economic integration from that of the last one, that ended in 1914?

Cargo vessel, c. 1910 Cargo vessel, c. 2010

EC120 Spring 2015: Week 25, Topic 20, Slide 3

EC120: The World Economy in Historical Perspective 1a. The changing character of globalization during the 20

century: trade in goods. • A study (Bordo, Eichengreen, and Irwin, NBER WP # 7195, (June, 1999)) argues that in terms of trade and capital flows (but not migration) the current phase of globalization is more extensive and pervasive than the last one.

• Trade in goods: the integration of manufacturing and commodity production now appears much closer than a century ago.

Cars awaiting export

EC120 Spring 2015: Week 25,Topic 20, Slide 4

EC120: The World Economy in Historical Perspective 1b. The changing character of globalization during the 20

century.• Factors promoting closer integration in goods production after 1945:

– The rise of foreign direct investment (FDI) is a particularly important reason for closer integration in manufacturing and commodity production.

– Transportation costs - an important driver of integration before 1914 - have continued to fall and new modes have appeared.

– Communication costs have fallen sharply while becoming more flexible

– Tariff barriers have also fallen sharply (see Bordo, et.al. (1999), Table 3). However, other measures less easily quantified - such as anti-dumping actions, ‘voluntary’ trade restraint agreements, etc. - have also been employed, possibly more effectively, for the purpose of protection.

Advanced FDI, 1914: Ford at Trafford Advanced FDI, 2014: Volkswagen

Park, Manchester in Chengdu, China

EC120 Spring 2015: Week 25, Topic 20, Slide 5

EC120: The World Economy in Historical Perspective 1c. The changing character of globalization during the 20

century: trade in services.• Trade in services, traditionally less traded, has also grown:

– For example, as in 1900, shipping and tourism are still the two largest categories of U.S. service exports, but whereas they accounted for virtually 100% of American service exports in 1900, they now account for only some 40%. Trends in Europe are similar.

– In 1900, the ratio of service exports to service total value-added was virtually nil (well under 1%). By 1960, it had risen only to 1.7%, then tripling to 1997, reaching 5.1% at a time when service output was itself growing markedly more rapidly than the economy as a whole.

– As with manufacturing, so with services: FDI is also an important means by which services such as banking and insurance are sold abroad. Such sales also encourage technological transfer in services (e.g. derivatives trading).

Deutsche Bank Trading Floor, London

EC120 Spring 2015: Week 25, Topic 20, Slide 6

EC120: The World Economy in Historical Perspective 1d. The changing character of globalization during the 20 century:

financial integration.• As in the years before 1914, trade integration since 1945 has

been accompanied by financial integration. − While capital flows in the recent past are, relative to the GDP of the

largest investing countries, still smaller than those of the last decade before the ‘Great War’, they now come from more countries and reach a broader range of countries and activities. Thus global capital flows, over business cycles, are in total larger now relative to the aggregate sizes of both sending and receiving economies.

− While not neglecting government finance and infrastructure projects, the main focus of foreign investment before 1914, foreign investment is now more heavily directed towards equities and concentrated on private sector manufacturing and services (for estimates of shares of private-source debt flows by recipient in the period 1865 to 1913, see Eichengreen & Bordo (2002), Table 4).

− There are more sources of foreign investment flows (such as Taiwanese investment in mainland China)

− In any case, as mentioned above, FDI (a special case of equity investment) now makes up a much larger proportion of total foreign investment than was the case before 1914, when portfolio investment dominated foreign lending.

EC120 Spring 2015: Week 25, Topic 20, Slide 7

EC120: The World Economy in Historical Perspective 1e. The changing character of globalization during the 20 century:

explanations.• What factors best account for increased international economic integration

(excluding migration) since 1945 (and especially since 1979)? Bordo et. al. (1999), (2002) propose the following:– broad macroeconomic stability, much more akin to pre-1914

international conditions than those of the 1920s and 1930s, yet without the extensive trade and capital controls of the 1950s and 1960s.

– better information and investor infrastructure (such as regulations governing corporate disclosure required by agencies such as the American SEC; IMF reports; etc.) to guide foreign investment, especially FDI.

– greater levels of social insurance to cushion trade shocks, thereby encouraging greater political support for international trade and capital flows.

– the growth of politically powerful advocates of trade, countering pressure groups seeking protection; as before 1914, the political strength of such advocates of openness varies from country to country.

EC120 Spring 2015: Week 25, Topic 20, Slide 8

EC120: The World Economy in Historical Perspective 2. Globalization and financial crises.• In view of the catastrophe of the 1930s and the financial crisis of 2008, it

is important to ask how robust the current phase of globalization is with respect to financial crises. In particular, how well suited to current circumstances is the current international monetary regime, which might be characterized as lightly managed flexibility (of necessity) among large convertible currency blocs (dollar, euro, yen and sterling, all components of SDRs), of which uniquely the euro is composed of ultra-tight pegs among members. All other currencies more or less track one or more of the big blocs. These arrangements are in strong contrast to the near universal hard pegs of the strongest economies during the classical Gold Standard period, with all other currencies floating.

N The large currency blocs can deploy both monetary and fiscal policy to

maintain macroeconomic stability, although individual Euro-zone countries have no control over monetary policy, which is entirely

in the hands of the European Central Bank. Does inflation targeting

encourage stabilizing co-ordination among the large currency blocs?

EC120 Spring 2015: Week 25, Topic 20, Slide 9

EC120: The World Economy in Historical Perspective 2a. Globalization and financial crises: definitions.• In the period 1945-1973, due to heavy controls, there were few

international financial crises. The currently available evidence suggest that crises in the period 1973-1997 were growing more frequent than those in the period 1880-1913, but not more severe, as measured by lost output or protracted recovery time. For the number of crises by period and market, see Eichengreen and Bordo, (2002), Table 6. For a summary of output losses (as a percentage of GDP), see their Table 7. Note that 21 countries are covered 1880-1913, while both the same 21 countries and an additional 35 countries are covered 1973-1997.– Three types of crisis: currency, banking, and ’twin’ (currency

and banking combined). The definitions are:• currency: forced change of parity, or abandonment of a

pegged exchange rate, or an international rescue, or, more subtly, Exchange Market Pressure: the movement, one and a half standard deviations above its mean in the relevant period, of an index (calculated as a weighted [equally?] average of: (a) the percentage change in the exchange rate; (b) the change in short-term interest rate differentials; (c) and the percentage change in reserves, all relative to the same variables in the centre country - before 1914, Britain; 1945–1973, the U.S.; after 1973, the U.S., Germany, or Japan, depending upon the crisis.

EC120 Spring 2015: Week 25, Topic 20, Slide 10

EC120: The World Economy in Historical Perspective 2a [con’t]. Globalization and financial crises: definitions.– Three types of crisis: currency, banking, and ’twin’ (currency and

banking combined). The definitions are [con’t.]:• banking: significant runs on money centre banks, widespread

bank failures, and the suspension of convertibility of deposits into currency such that currency circulates at a premium relative to deposits, or significant banking sector problems resulting in the erosion of most or all of banking system collateral, an erosion that is ultimately resolved by a fiscally-underwritten bank restructuring.

• ‘twin’: both a currency crisis and a banking crisis occurring in the same or immediately adjacent years.

• output losses: calculated as the sum of the differences between actual GDP growth and the five year average preceding the crisis, until growth returns to trend (as cumulative proportion of trend GDP). Note that this calculation is sensitive to the precise measure used. A longer averaging period tends to lessen measured losses (because growth tends to accelerate in the years just before a crisis).

• recovery time: calculated as the number of years before the rate of GDP growth returns to its pre-crisis average, defined in terms of the five years preceding the crisis.

EC120 Spring 2015: Week 25, Topic 20, Slide 11

EC120: The World Economy in Historical Perspective 2b. Globalization and financial crises: summary overview.• Summary of conclusions regarding crises (c. 2006):– ‘Twin’ crises (fortunately a minority of crises in both periods) do seem to be becoming both more frequent and more severe (again, the

increased number of countries covered may artificially magnify ‘intrinsic’ frequency). However, more recent work by Bordo and Murshid (2006), drawing a distinction between international and coincidental crises, suggests that truly international crises are not more prevalent in the recent period (at least until 2008).

–Bordo and Murshid (2006) suggest that severing the links to gold in

favour of a managed floating regime, the growing financial maturity of advanced countries, and the widening of the number of major financial centres has reduced the incidence of global crises.

– The pre-1914 international monetary regime seems to have worked better in limiting the tendency for banking crises to

destabilize currency markets, but only for the ‘core’ industrial economies. Emerging markets in both periods have found the extent of crises (in terms of accumulated losses and recovery time) similar.

EC120 Spring 2015: Week 25, Topic 20, Slide 12

EC120: The World Economy in Historical Perspective 2c. Globalization and financial crises: the build-up of debt and leverage.

• In light of the current financial crisis, recent views, such as those of Eichengreen and Bordo (2002) and Bordo and Murshid (2006) are likely to be modified, although it is still too soon to know just how the current crisis will be resolved.• The current crisis has some familiar features, especially rapid and persistent build up of debt (combined with greater leverage) in the years immediately preceding the crisis, as in the UK and Spain and, to a somewhat lesser extent, in South Korea, France, and the US. (See Lund & Roxburgh (2010), Fig 1.). There were also some important differences, notably: (1) the suddenness and extent of its global onset, affecting both trade surplus and trade deficit countries equally; (2) its initial concentration in the financial sectors of many countries, both those with trade surpluses and trade deficits simultaneously.• The structure of debt across categories (financial institutions, households, non- financial businesses, and governments) varies widely across countries, suggesting that the strategies for bringing debt under control (deleveraging) will also vary widely. (See Lund & Roxburgh (2010), Figs. 2, 3, & 4).

EC120: The World Economy in Historical Perspective 2d. Globalization and financial crises: possible

consequences.• Widespread changes in financial regulation to make it more

unlikely that the credit losses of financial institutions can occur so suddenly and with such devastating impact.

• Reinhart & Rogoff stress that depressed demand (and related deflationary pressures), protracted weak income growth, depressed asset prices (especially housing), and elevated unemployment are the characteristic consequences of severe financial crises, and may be exacerbated by proposed reforms (such as restrictions on bank lending).

Recent

political protests

in Athens

EC120 Spring 2015: Week 25, Topic 20, Slide 13

EC120 Spring 2015: Week 25, Topic 20, Slide 14

EC120: The World Economy in Historical Perspective 3. The outlook after the crash • Reinhart & Rogoff, among others, argue that high levels of debt

(both public and private) work against rapid recovery from the 2007-08 global financial crisis. Hence the near-term outlook is one of a slow, fragile, tentative resumption of growth.

• As always, the longer-term outlook will be determined by the productivity advance made possible by technolgy and economic reform.

• Although the near-term outlook is not over-bright, the global economy has not (yet) succumbed to an economic (and political) catastrophe comparable to the 1930s, although the experience of some countries has come close. Something has been learned. Time will tell if it’s enough.

Wall Street, October 1929 Lehman Bros. ex-employee, London, Sept. 2008