Published: April 8 2007 17:27 | Last updated: April 8 2007 17:27
The balance of winners and losers
Suppose for the sake of argument – it is not a prediction – that the financial markets were to fall heavily in the near future. The obvious culprit would be a US recession. But suppose the opposite – that the collapse had no external causes, but was simply the bursting of a bubble. What would that do to the real economy?
Not a lot, according to the prominent academic Willem Buiter. Movements in financial markets create winners and losers in equal measure. Subject to certain conditions – which we shall come to – even a market crash is a zero sum game.
As Professor Buiter is careful to emphasise, this does not mean financial markets are unimportant. They perform a vital economic service in allowing real assets to be efficiently allocated. But it is enough that they should exist. How they behave thereafter is irrelevant.
I have tried this proposition on a couple of fund managers and the response has been apoplectic. This is hardly surprising. As a fund manager, you are paid to make money. If you lose your shirt in the markets, it is small consolation that the cash entrusted to you has been nabbed by somebody else.
Inside and outside
But is that really what happens in a crash? Begin with a distinction Prof Buiter makes between “inside” and “outside” assets. The former simply involve a claim by one party on another. The classic case is derivatives, which really are a zero sum game. One player’s gain is another’s loss and the outcome has no more effect on the outside world than a horse race.
What about a collapse in the price of government bonds? It seems to me – Prof Buiter disagrees – that the effect rather depends on the cause. In the case of runaway inflation, as in the 1970s, wealth would simply be transferred from lender to borrower. Savers would be hit, but the taxpayer would benefit in equal measure because of the lower real cost of repaying the loan.
A more likely cause these days would be a rise in real interest rates from what seem unsustainably low levels.
In that case, investors holding the bonds to maturity – such as pension funds – would be no worse off. They would still get the deal they signed up to – the same annual income and the same lump sum at the end. But once those bonds were cashed in, the fund might then use part of the proceeds to buy new bonds. They would then be better off, since their cash would buy them a larger income stream.
For taxpayers, the reverse would be true. They would be unaffected for the life of existing bonds, but would then have to stump up more to replace them.
In the case of equities, the position is slightly different. Obviously, there is no final lump sum. The whole value of a share consists of its title to a future stream of income. So if you are never going to sell it, you are theoretically indifferent to what the price does.
In reality, of course, investors buy and sell equities all the time. If they did not, the markets would not do their job of establishing prices. But this can still be seen as a zero sum between buyer and seller. If I sell to you at a loss, you gain to an equal extent through securing the same income stream at a lower price. Or perhaps the share price has fallen because the income stream is impaired – that is, the company is in trouble. If so, bad luck. But there is still a matching winner – whoever sold you the share for more than it was worth in the first place.
Back to the real world
So far, so theoretical. But from the viewpoint of the whole economy, as Prof Buiter says, this all assumes the behaviour of winners and losers is symmetrical. If winners bury their winnings at the bottom of the garden, so much the worse for the economy. The same is true if – as is more likely – losers go bust.
Even that need not be a calamity. If a manufacturer goes under, a rival benefits by taking market share and perhaps by picking up assets cheap from the receiver. But if a big investment bank were to go bust there could be all kinds of behavioural effects, including a reduction in the propensity of borrowers to borrow and lenders to lend.
The other big real-world losers from a market crash, of course, would be pension funds. Under today’s accounting rules, a fall in the price of equities (though not of bonds) creates deficits. Companies are under various pressures, some of them regulatory, to make those deficits good. So far, there is no real evidence this has weakened their ability to invest in the business, but that plainly cannot be ruled out in future.
So we cannot afford to be complacent. But on the whole, it seems to me Prof Buiter’s argument stands. If the market dives because of a repricing of risk, the effects will with luck be contained. And conversely, if the US economy really does hit trouble, the market reaction could be the least of our problems.
Friday, 3 August 2007
Globalisation and Inflation
“Globalisation and Inflation” by CHARLES BEAN
EXECUTIVE DIRECTOR AND CHIEF ECONOMIST OF THE BANK OF ENGLAND
To LSE Economics Society
London School of Economics Tuesday 24 October 2006
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Good evening! Googling “Globalisation” generates no fewer than 45 million hits1, so a lot of (virtual) ink has already been spilt on my topic tonight – though apparently rather less than on “Madonna”, given the 90 million hits that her name brings up. But the term is often used rather loosely – and sometimes abusively – to describe all sorts of phenomena.
So my talk will focus on just the impact of globalisation on the industrialised economies – and in particular on the inflation process – of the changes in economic geography brought about by the integration of China, India and the emerging economies of Eastern Europe into the world economy and the increased ease with which production can be relocated around the globe. Of course, the progressive development and integration of more countries into the international trading system is not a new phenomenon.
In the post-war era, we have seen first the rise of Japan, followed closely by the emergence of Korea and the other tiger economies of South-East Asia. But what is new this time is the sheer scale of events, with the entry of China, India and Eastern Europe into the global market economy effectively doubling that economy's labour supply, from roughly 1.5 billion to 3 billion. Now most of these extra workers are relatively unskilled and brought little capital with them into the world economy, so the effect has been to lower the ratios of skilled labour and physical capital to unskilled labour. This should then drive down the wages of unskilled labour relative to skilled labour, as well as driving up the rate of profit on capital.
And we should expect to see the production of goods and services that are intensive in the use of unskilled labour shifting to these emerging economies, with production in the industrialised countries shifting towards goods and services that are more intensive in the use of skilled labour – let us call them knowledge-based industries. That is indeed pretty much what has been happening. Moreover, the integration of China, India and Eastern Europe into the global economy has coincided with an information and communications revolution that, along with falling transport costs, has made it feasible to push the division of labour ever further. So it is not just the production of labour-intensive goods that has been shifting eastwards, but also the labour-intensive elements within production cycles.
So a product might be designed in an industrialised country such as the United Kingdom, but assembled in a country such as China, in turn using parts manufactured in surrounding countries. The geographical origin of a product becomes debatable in these circumstances: “Made in China” would often be more accurately rendered as “Assembled in China”. Moreover, after-sales service might rely on a call-centre based in India to record problems _____________________________________________________________________ 1You need to search on both “Globalisation” and “Globalization”!
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and utilise domestic workers to undertake the repairs. This unbundling of the production process into its constituent tasks, and the reallocation of those tasks to places with a comparative advantage in undertaking them, has increased the scope for businesses in the industrialised world to organise production in the most cost-effective manner possible. But this downward pressure on the wage of unskilled labour relative to that of skilled labour does not imply that unskilled labour in the industrialised economies is necessarily worse off.
The resulting exploitation of the gains from trade means that the developed economies have access to some goods and services more cheaply than they can be produced at home – it is similar to discovering a new and more efficient technology. So the purchasing power of unskilled workers’ wages may rise, even though their wages relative to those of skilled labour may have fallen.
And it is even possible that the demand for unskilled labour in the domestic economy could actually rise. That could happen if some domestic unskilled labour is still necessary in production even after other tasks have been offshored, and if the decline in costs and fall in price stimulate a large enough increase in the demand for the product2. So evaluating the ultimate impact of globalisation on the living standards of unskilled workers in the industrialised economies is by no means straightforward.
Labour Force Survey data suggest that, in the United Kingdom at least, any adverse effect on the living standards of unskilled workers has been nugatory at best, as average gross weekly earnings for elementary workers actually grew at a slightly faster rate between 1995 and 2006 than those for all workers, though that may reflect in part the impact of the National Minimum Wage. Not everything has gone according to the economics textbook though. We would also have expected to see investment picking up in the emerging economies, with capital flowing from the industrialised countries, where it is abundant, to the emerging economies, where it is scarce.
And if emerging-economy households are able to borrow against their higher expected future income, we might also expect to see consumption picking up. So we should be observing a current account deficit in the emerging economies and a surplus on their capital accounts. Investment certainly has picked up – in China it has touched an astonishing 45% of national output. But instead of running current account deficits, countries such as China have instead been running a surplus. Capital, far from flowing from the rich industrialised countries to the emerging economies, has tended to flow the other way, in particular to the United States (Chart 1). _____________________________________________________________________ 2For further analysis of trade in tasks and its effects, see Gene Grossman and Esteban Rossi-Hansberg, 2006, “The riseof offshoring: It's not wine for cloth anymore”, Federal Reserve Bank of Kansas City Symposium, Jackson Hole.
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3Why might this have happened? One explanation is that it reflects a deliberate policy choice. The Asia crisis of 1997-98 revealed that developing countries relying on footloose foreign capital to finance investment were vulnerable to sudden stops or reversals in those capital flows. That has made emerging economies more inclined to rely on domestic savings to finance their investment.
In China's case, this has partly been through substantial saving by the official sector, and in particular by the accumulation of foreign reserves, particularly US treasuries, that are approaching $1 trillion. Moreover, corporate saving has been unusually high in China, while the absence of a significant social safety net has also encouraged households to maintain high rates of savings in order to build up a store of wealth for precautionary purposes.
A second explanation is that the capital markets in these countries are relatively underdeveloped, and the institutions for intermediating funds from savers to investors are relatively inefficient. That means that they may be relatively less effective at utilising capital inflows, other than through foreign direct investment, i.e. when foreign companies invest directly in subsidiaries domiciled in the emerging economy or via joint ventures. By contrast, the US financial markets are deep and liquid and still offer an attractive home for overseas investors3. One other macroeconomic oddity that is also worth noting is the behaviour of global real interest rates. Standard economic analysis would suggest that the increased demand for investment goods resulting from the increase in global labour supply ought to drive up the world real interest rate. But world real interest rates have tended to fall over the past few years (see Chart 2; I focus on longer-term rates in order to abstract from short-term movements associated with the business cycle). That is something that former Fed Chairman, Alan Greenspan, described as a “conundrum”. The current Fed Chairman, Ben Bernanke, has attributed it to an unusually high level of global savings4– a “savings glut” – not just because much of the investment in the emerging economies has been financed by domestic savings, but also because of high rates of savings in Japan and the European Union driven by the ageing of their workforces. It is also possible that the rapid growth in global liquidity during the early years of the millennium may have played a part.
Let me now turn to the aspect of globalisation that is of particular concern to central bankers, namely its impact on inflation. The past fifteen years have seen inflation rates settle at low levels _____________________________________________________________________
3See Eswar Prasad, Raghu Rajan and Arvind Subramanian, 2006, “Patterns of international capital flows and their implications for economic development”, Federal Reserve Bank of Kansas City Symposium, Jackson Hole; and RicardoCaballero, Emmanuel Farhi and Pierre-Olivier Gourinchas, 2006, “An equilibrium model of global imbalances and low interest rates”, Centre for Economic Policy Research Discussion Paper 5573, April. 4See Ben Bernanke, 2005, “The global saving glut and the US current account deficit”, Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia.
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4throughout the industrialised world (Chart 3). And many countries in the developing world, which had previously experienced high inflation, have seen it falling. If you ask the average businessman or woman why this is the case, he or she is almost certain to reply that it is down to cheap imports from the Far East and Eastern Europe. Monetary policy probably won’t get a mention.
Yet you will all know from your first-year macroeconomics course that this can’t be right, as inflation must ultimately be a monetary phenomenon. So how can we reconcile the business view with that of the economist?The answer, of course, is that globalisation essentially represents a shock to relative prices, not the absolute price level. Imports are only one part of the consumption basket, and what happens to the general price level also depends on what happens to the prices of domestically-produced goods and services.
The prices of tradable goods that are close substitutes for the imports may be driven down, but the prices of other goods and especially non-tradable services can rise faster. This may happen automatically, if consumers react to the rise in purchasing power associated with cheaperimports to increase their spending on other goods and services, driving up their prices. But even if it doesn’t, the overall inflation rate should in the long run remain unchanged, provided that the monetary authorities ensure that steady growth in overall nominal demand is maintained through an appropriate monetary policy.
If a country does not fix its exchange rate and is free to pursue an independent monetary policy, it can ultimately always choose its own inflation rate. That is graphically illustrated in Chart 4, which shows the inflation rates of goods and services separately. For much of the past decade, goods price inflation was depressed by the increased availability of cheap imports, especially from Asia. But that was offset to a degree by relatively rapid inflation in the less internationally tradable services category.
Note, however, the recent pickup in the rate of inflation in goods prices as the effect of the increase in energy prices since 2004 and buoyant global demand works through, together with the corresponding decline in services inflation. But this does not mean that globalisation has been irrelevant for the inflation process in the industrialised economies.
Recall first that the standard view suggests that inflation is related both to the level of demand relative to potential supply – the output gap – and to expected inflation. Activity can only run ahead of potential supply in the economy so long as inflation runs ahead of expectations. Any attempt systematically to exploit this short-run trade-off is ultimately doomed to failure as inflation expectations will eventually adjust. That is an insight that won Ned Phelps this year’s Nobel Prize for economics. But globalisation affects this story in a number of ways.
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5First of all, movements in the terms of trade – the price of exports relative to that of imports – associated with globalisation potentially alters the level of activity that is consistent with stable inflation. Thus the availability of cheap imports from Asia has acted very much like a positive supply shock, boosting potential supply.
That is because UK businesses’ demand for labour depends inversely on the cost of that labour relative to the price of their output, while workers’ supply of labour depends on the purchasing power of their earnings, some of which is spent on imported goods. So a fall in the price of imports relative to domestic goods allows workers to enjoy higher real wages without any cost to their employers. This then tends to raise the equilibrium level of employment in the economy.
In effect then, the beneficial terms of trade shock provides a favourable ‘tailwind’, allowing central banks to run the economy at a higher level of activity than would otherwise have been the case, or else to bring inflation down without having to squeeze down on growth. But empirical studies – many of them carried out at the Centre for Economic Performance here at LSE – suggest that this effect may only be temporary, possibly because workers start building into their wage aspirationsthe extra increase in living standards from the terms of trade gain. That suggests we should not count on it continuing. Moreover, the development of China and India has been something of a double-edged sword, as rapid Asian growth has been a major driver of the tripling of oil prices since early 2004, as well pushing up the prices of non-oil commodities substantially.
Countries importing these commodities have therefore suffered an increase in the price of these imports that offsets to some degree the gain from access to low-cost goods. Even for a country like the United Kingdom, which is roughly self-sufficient in oil, the rise in the oil price will still initially redistribute income away from households and non-oil businesses and towards the oil companies and the government. Should workers resist the consequent decline in the purchasing power of their wages, the level of potential supply would be adversely affected.
The second potential effect of globalisation is on the short-run dynamics of the inflation process. One of the most notable developments of the past decade or so has been the apparent flattening ofthe short-run trade-off between inflation and activity. That is particularly obvious in the case of the United Kingdom (Chart 5), but can also be observed in many other countries (e.g. Chart 6 for the United States). As can be seen, the Seventies were characterised by an almost vertical relationship in the United Kingdom, in which any attempt to hold unemployment below its natural rate resulted in rising inflation.
In the Eighties, the downward sloping relationship reappears, as inflation was squeezed out of the system by the slack in the economy. However, since the early Nineties, the relationship looks to have been rather flat. Now in theory, it is possible that this just reflects our extraordinarily precise management of aggregate demand, which has kept unemployment exactly in line with a falling natural rate.
But while macroeconomic policy may have been much better over this period, it defies belief that it was that much better. Instead it looks as if the inflation process itself may have changed in some way. Part of the story probably is connected to the change in policy regime, though in a more subtle fashion.
Inflation targeting appears to have kept inflation expectations well-anchored (Chart 7), whereas in the past falling unemployment might have led to expectations of higher future inflation, adding to the upward pressures on current inflation. Moreover, businesses need to raise prices less frequently to keep up with inflation when its average rate is low, so that increases in demand are less likely to lead to an increase in the overall price level, at least in the short run.
But the structural consequences of globalisation also seem to have flattened the short-run trade-off between inflation and the domestic output gap through a variety of channels. First, the increased trade and specialisation associated with globalisation reduces the response of inflation to the domestic output gap, and at the same time potentially makes it more sensitive to the balance between demand and supply in the rest of the world5.
A recent study carried out at the Bank for International Settlements by Claudio Borio and Andy Filardo finds some empirical support for this proposition across a range of countries. Second, increased competition from labour-abundant economies may reduce the cyclical sensitivity of profit margins, as businesses have less scope to raise their prices when domestic demand increases.
So assuming that marginal costs rise with output, we would expect that the mark-up of price over marginal cost will tend to be squeezed more when demand rises (and vice versa, when it falls). Work carried out at the Bank by former MPC member, Steve Nickell, together with Nicoletta Batini and Brian Jackson7finds that this indeed seems to be the case.
See, for instance: Jordi Gali and Tomasso Monacelli, 2005, “Monetary policy and exchange rate volatility in a small open economy”, Review of Economic Studies, Vol. 72, pp707-734; and Razin, Assaf and Chi-Wa Yuen, 2002, “The‘New Keynesian’ Phillips curve: Closed economy vs. open economy”, Economics Letters, Vol. 75, May, pp.1-9. 6Claudio Borio and Andrew Filardo, 2006, “Globalization and inflation: New cross-country evidence on the globaldeterminants of domestic inflation”, mimeo, Bank for International Settlements, Basle. 7Nicoletta Batini, Brian Jackson, and Stephen Nickell, 2005, “An open economy New Keynesian Phillips curve for the UK”, Journal of Monetary Economics, vol. 52, pp. 1061-1071.
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Third, production costs may also have become less sensitive to the state of the business cycle. The increased ease with which activities can be off-shored to China, India or Eastern Europe will make workers less inclined to push for higher wages when unemployment falls, and stiffen the hand of employers in resisting such claims, so limiting the effect of higher activity on the marginal cost of labour. Moreover, there is an additional factor in the case of the United Kingdom, in the shape of increased inward migration.
Official migration estimates – though it should be emphasised that there is very considerable uncertainty over the true magnitude – together with a reasonable assumption about migrants’ labour force participation suggests that migration probably accounts for around two-thirds of the increase in the workforce since 1997. The size of this flow, particularly from the Accession countries of Eastern Europe, reflects in part the substantial wage differentials between the United Kingdom and the migrants’ home country, but the magnitude of the flow is also likely to vary in line with the tightness of the UK labour market.
And businesses are increasingly used to sourcing their workers from abroad, often through the use of specialised agencies. So if they are finding it difficult to get the additional workers they need, rather than bidding up wages to attract them from other firms, they may instead simply look to get them from abroad.
The migration resulting fromthe increased international mobility of labour therefore represents another force that weakens the link between activity and the cost of labour. These three factors – increased specialisation; the intensification of product market competition;and the impact of that intensified competition and migration on the behaviour of wages – should all work to flatten the short-run trade-off between inflation and domestic activity.
But it is worth mentioning one consequence of globalisation that might work in the opposite direction. An increase in the competitive pressures in product markets will mean that the profits foregone by setting a price at the “wrong” level will be all the greater. That would encourage businesses to revise their prices more frequently, and will tend to steepen, rather than flatten, the trade-off8. That is in the opposite direction from the likely impact of moving to an environment of low inflation that I mentioned earlier. By way of providing some evidence on this, we recently asked our regional Agents to conduct a small survey of some of their business contacts in order to see how the frequency of price changes _____________________________________________________________________ 8See Ken Rogoff, 2003, “Globalization and global disinflation”, in Federal Reserve Bank of Kansas City, Monetary Policy and Uncertainty: Adapting to a Changing Economy, pp.77-112.
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had changed over the past decade. Chart 8 shows the results, broken down by sector9. There is a marked tendency towards an increased frequency of price changes in virtually all sectors, including in manufacturing which is probably the sector most exposed to the effects of globalisation.
The increase in the frequency of price changes in retailing is particularly striking and probably reflects the dramatic intensification of competition in that sector – the “Tesco effect” – as well as the consequences of technological advances that make the fine tuning of prices easier. The extent to which the flattening of the short-run inflation-activity trade-off is down to globalisation, and the extent to which it is associated with the change in monetary regime is ultimately an empirical matter. There are cross-country empirical studies that suggest that it is indeed flatter in more open economies10.
And there are also studies that suggest that the change in the conduct of monetary policy has been important11. So both factors are likely to be at work. Perhaps even more important than the way globalisation has affected the response of inflation to demand is the way that it appears to have altered the response to cost shocks. If you had told the MPC in early 2004 that oil prices would triple over the following two years, I think we would have been very worried indeed about the possible inflationary impact, notwithstanding the fact that it was partly associated with the same globalisation forces that were helping to drive down the prices of imported goods.
While the oil intensity of production today is about half what it was in the Seventies, we would nevertheless have been concerned that the higher cost of energy would lead to so-called second-round effects on wages as workers sought to maintain the purchasing power of their earnings, as well as on to the prices of other goods and services. In the event, pay growth has so far remained remarkably stable (Chart 9). Indeed far from picking up over the past year or so, it has actually eased.
Since consumer price inflation has picked up during that time, the rate of growth of the purchasing power of those wages (the real consumption wage in Chart 10) has slowed and ensured that the real wage in terms of the price of UK output (the real product wage) has grown more or less in line with trend productivity growth. One reason why wage growth may have been so subdued is that unemployment has edged up since early 2005. But that appears not to be the whole story. Exactly the same heightened competitive _____________________________________________________________________ 9The original version of this speech included a somewhat different version of this Chart and contained a calculation error.10See e.g. Joseph Daniels, Farrokh Nourzad and David Vanhoose, 2005, “Openness, central bank independence, and the sacrifice ratio”, Journal of Money, Credit and Banking, Vol. 37(2), April, pp.371-379. 11See e.g. Luca Benati, 2005, “The inflation-targeting framework from an historical perspective”, Bank of England Quarterly Bulletin, Vol. 45(2), Summer, pp.160-168.
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pressures in product markets that appear to have contributed to the flattening of the inflation-activity trade-off, may also have affected the way that businesses have responded to the increase in energy costs. Rather than immediately pass on in full such increases in higher prices, it appears that they may have instead looked to lower other costs, either by granting lower wage increases, or by putting downward pressure on the prices of intermediate inputs, or by raising efficiency.
Our regional Agents have also asked a sample of their business contacts how they have responded to the squeeze in profit margins occasioned by the rise in energy costs. The survey suggested that relatively few businesses expected to be able to raise prices and instead planned to raise efficiency, reduce employment or push down on wage and other costs (Chart 11).
And some respondents felt they had little alternative but to accept the hit on their margins. That was especially the case in manufacturing, which is the sector that is most exposed to international competition. The consequence of this is that, far from seeing second-round effects on wages and other prices as energy costs have risen, if anything they so far seem to have acted as a bit of a cushion.
That is illustrated in Chart 12, which shows the contribution to inflation of the domestic non-energy component of consumer prices for the United Kingdom, United States, the euro area and Canada since 1993 plotted against the contribution of energy and import prices, which can be treated as being largely exogenous to each region. (For clarity and to allow for different average overall inflation rates, the inflation components are presented as deviations from regional averages.) There are clear signs of an inverse correlation in all regions, though the relationship is certainly far fromperfect.
But if this relationship continues to hold in the future, then we might expect the beneficial effect on inflation from the recent fall in oil prices to be partly offset by faster inflation in the non-energy components of consumer price inflation as businesses seek to rebuild their profit margins and workers make up for the squeeze on the purchasing power of their wages. (Some commentators have interpreted this as implying that a rise in oil prices is bad news and a fall in oil prices is also bad news.
That, of course, is nonsense. The presence of a countervailing response of non-energy price inflation to changes in energy price inflation just means that a rise in oil prices is not such bad news for inflation as it first appears, and that a fall in oil prices is not suchgood news as it first appears.) Finally, some brief words on how the changes in inflation dynamics that appear to be down in part to the impact of globalisation might affect the conduct of monetary policy. Clearly the reduced pass-through of energy cost increases into wages and prices is good news for central banks. But the flattening of the inflation-activity trade-off is rather more of a mixed blessing. On the one hand,
EXECUTIVE DIRECTOR AND CHIEF ECONOMIST OF THE BANK OF ENGLAND
To LSE Economics Society
London School of Economics Tuesday 24 October 2006
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Good evening! Googling “Globalisation” generates no fewer than 45 million hits1, so a lot of (virtual) ink has already been spilt on my topic tonight – though apparently rather less than on “Madonna”, given the 90 million hits that her name brings up. But the term is often used rather loosely – and sometimes abusively – to describe all sorts of phenomena.
So my talk will focus on just the impact of globalisation on the industrialised economies – and in particular on the inflation process – of the changes in economic geography brought about by the integration of China, India and the emerging economies of Eastern Europe into the world economy and the increased ease with which production can be relocated around the globe. Of course, the progressive development and integration of more countries into the international trading system is not a new phenomenon.
In the post-war era, we have seen first the rise of Japan, followed closely by the emergence of Korea and the other tiger economies of South-East Asia. But what is new this time is the sheer scale of events, with the entry of China, India and Eastern Europe into the global market economy effectively doubling that economy's labour supply, from roughly 1.5 billion to 3 billion. Now most of these extra workers are relatively unskilled and brought little capital with them into the world economy, so the effect has been to lower the ratios of skilled labour and physical capital to unskilled labour. This should then drive down the wages of unskilled labour relative to skilled labour, as well as driving up the rate of profit on capital.
And we should expect to see the production of goods and services that are intensive in the use of unskilled labour shifting to these emerging economies, with production in the industrialised countries shifting towards goods and services that are more intensive in the use of skilled labour – let us call them knowledge-based industries. That is indeed pretty much what has been happening. Moreover, the integration of China, India and Eastern Europe into the global economy has coincided with an information and communications revolution that, along with falling transport costs, has made it feasible to push the division of labour ever further. So it is not just the production of labour-intensive goods that has been shifting eastwards, but also the labour-intensive elements within production cycles.
So a product might be designed in an industrialised country such as the United Kingdom, but assembled in a country such as China, in turn using parts manufactured in surrounding countries. The geographical origin of a product becomes debatable in these circumstances: “Made in China” would often be more accurately rendered as “Assembled in China”. Moreover, after-sales service might rely on a call-centre based in India to record problems _____________________________________________________________________ 1You need to search on both “Globalisation” and “Globalization”!
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and utilise domestic workers to undertake the repairs. This unbundling of the production process into its constituent tasks, and the reallocation of those tasks to places with a comparative advantage in undertaking them, has increased the scope for businesses in the industrialised world to organise production in the most cost-effective manner possible. But this downward pressure on the wage of unskilled labour relative to that of skilled labour does not imply that unskilled labour in the industrialised economies is necessarily worse off.
The resulting exploitation of the gains from trade means that the developed economies have access to some goods and services more cheaply than they can be produced at home – it is similar to discovering a new and more efficient technology. So the purchasing power of unskilled workers’ wages may rise, even though their wages relative to those of skilled labour may have fallen.
And it is even possible that the demand for unskilled labour in the domestic economy could actually rise. That could happen if some domestic unskilled labour is still necessary in production even after other tasks have been offshored, and if the decline in costs and fall in price stimulate a large enough increase in the demand for the product2. So evaluating the ultimate impact of globalisation on the living standards of unskilled workers in the industrialised economies is by no means straightforward.
Labour Force Survey data suggest that, in the United Kingdom at least, any adverse effect on the living standards of unskilled workers has been nugatory at best, as average gross weekly earnings for elementary workers actually grew at a slightly faster rate between 1995 and 2006 than those for all workers, though that may reflect in part the impact of the National Minimum Wage. Not everything has gone according to the economics textbook though. We would also have expected to see investment picking up in the emerging economies, with capital flowing from the industrialised countries, where it is abundant, to the emerging economies, where it is scarce.
And if emerging-economy households are able to borrow against their higher expected future income, we might also expect to see consumption picking up. So we should be observing a current account deficit in the emerging economies and a surplus on their capital accounts. Investment certainly has picked up – in China it has touched an astonishing 45% of national output. But instead of running current account deficits, countries such as China have instead been running a surplus. Capital, far from flowing from the rich industrialised countries to the emerging economies, has tended to flow the other way, in particular to the United States (Chart 1). _____________________________________________________________________ 2For further analysis of trade in tasks and its effects, see Gene Grossman and Esteban Rossi-Hansberg, 2006, “The riseof offshoring: It's not wine for cloth anymore”, Federal Reserve Bank of Kansas City Symposium, Jackson Hole.
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3Why might this have happened? One explanation is that it reflects a deliberate policy choice. The Asia crisis of 1997-98 revealed that developing countries relying on footloose foreign capital to finance investment were vulnerable to sudden stops or reversals in those capital flows. That has made emerging economies more inclined to rely on domestic savings to finance their investment.
In China's case, this has partly been through substantial saving by the official sector, and in particular by the accumulation of foreign reserves, particularly US treasuries, that are approaching $1 trillion. Moreover, corporate saving has been unusually high in China, while the absence of a significant social safety net has also encouraged households to maintain high rates of savings in order to build up a store of wealth for precautionary purposes.
A second explanation is that the capital markets in these countries are relatively underdeveloped, and the institutions for intermediating funds from savers to investors are relatively inefficient. That means that they may be relatively less effective at utilising capital inflows, other than through foreign direct investment, i.e. when foreign companies invest directly in subsidiaries domiciled in the emerging economy or via joint ventures. By contrast, the US financial markets are deep and liquid and still offer an attractive home for overseas investors3. One other macroeconomic oddity that is also worth noting is the behaviour of global real interest rates. Standard economic analysis would suggest that the increased demand for investment goods resulting from the increase in global labour supply ought to drive up the world real interest rate. But world real interest rates have tended to fall over the past few years (see Chart 2; I focus on longer-term rates in order to abstract from short-term movements associated with the business cycle). That is something that former Fed Chairman, Alan Greenspan, described as a “conundrum”. The current Fed Chairman, Ben Bernanke, has attributed it to an unusually high level of global savings4– a “savings glut” – not just because much of the investment in the emerging economies has been financed by domestic savings, but also because of high rates of savings in Japan and the European Union driven by the ageing of their workforces. It is also possible that the rapid growth in global liquidity during the early years of the millennium may have played a part.
Let me now turn to the aspect of globalisation that is of particular concern to central bankers, namely its impact on inflation. The past fifteen years have seen inflation rates settle at low levels _____________________________________________________________________
3See Eswar Prasad, Raghu Rajan and Arvind Subramanian, 2006, “Patterns of international capital flows and their implications for economic development”, Federal Reserve Bank of Kansas City Symposium, Jackson Hole; and RicardoCaballero, Emmanuel Farhi and Pierre-Olivier Gourinchas, 2006, “An equilibrium model of global imbalances and low interest rates”, Centre for Economic Policy Research Discussion Paper 5573, April. 4See Ben Bernanke, 2005, “The global saving glut and the US current account deficit”, Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia.
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4throughout the industrialised world (Chart 3). And many countries in the developing world, which had previously experienced high inflation, have seen it falling. If you ask the average businessman or woman why this is the case, he or she is almost certain to reply that it is down to cheap imports from the Far East and Eastern Europe. Monetary policy probably won’t get a mention.
Yet you will all know from your first-year macroeconomics course that this can’t be right, as inflation must ultimately be a monetary phenomenon. So how can we reconcile the business view with that of the economist?The answer, of course, is that globalisation essentially represents a shock to relative prices, not the absolute price level. Imports are only one part of the consumption basket, and what happens to the general price level also depends on what happens to the prices of domestically-produced goods and services.
The prices of tradable goods that are close substitutes for the imports may be driven down, but the prices of other goods and especially non-tradable services can rise faster. This may happen automatically, if consumers react to the rise in purchasing power associated with cheaperimports to increase their spending on other goods and services, driving up their prices. But even if it doesn’t, the overall inflation rate should in the long run remain unchanged, provided that the monetary authorities ensure that steady growth in overall nominal demand is maintained through an appropriate monetary policy.
If a country does not fix its exchange rate and is free to pursue an independent monetary policy, it can ultimately always choose its own inflation rate. That is graphically illustrated in Chart 4, which shows the inflation rates of goods and services separately. For much of the past decade, goods price inflation was depressed by the increased availability of cheap imports, especially from Asia. But that was offset to a degree by relatively rapid inflation in the less internationally tradable services category.
Note, however, the recent pickup in the rate of inflation in goods prices as the effect of the increase in energy prices since 2004 and buoyant global demand works through, together with the corresponding decline in services inflation. But this does not mean that globalisation has been irrelevant for the inflation process in the industrialised economies.
Recall first that the standard view suggests that inflation is related both to the level of demand relative to potential supply – the output gap – and to expected inflation. Activity can only run ahead of potential supply in the economy so long as inflation runs ahead of expectations. Any attempt systematically to exploit this short-run trade-off is ultimately doomed to failure as inflation expectations will eventually adjust. That is an insight that won Ned Phelps this year’s Nobel Prize for economics. But globalisation affects this story in a number of ways.
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5First of all, movements in the terms of trade – the price of exports relative to that of imports – associated with globalisation potentially alters the level of activity that is consistent with stable inflation. Thus the availability of cheap imports from Asia has acted very much like a positive supply shock, boosting potential supply.
That is because UK businesses’ demand for labour depends inversely on the cost of that labour relative to the price of their output, while workers’ supply of labour depends on the purchasing power of their earnings, some of which is spent on imported goods. So a fall in the price of imports relative to domestic goods allows workers to enjoy higher real wages without any cost to their employers. This then tends to raise the equilibrium level of employment in the economy.
In effect then, the beneficial terms of trade shock provides a favourable ‘tailwind’, allowing central banks to run the economy at a higher level of activity than would otherwise have been the case, or else to bring inflation down without having to squeeze down on growth. But empirical studies – many of them carried out at the Centre for Economic Performance here at LSE – suggest that this effect may only be temporary, possibly because workers start building into their wage aspirationsthe extra increase in living standards from the terms of trade gain. That suggests we should not count on it continuing. Moreover, the development of China and India has been something of a double-edged sword, as rapid Asian growth has been a major driver of the tripling of oil prices since early 2004, as well pushing up the prices of non-oil commodities substantially.
Countries importing these commodities have therefore suffered an increase in the price of these imports that offsets to some degree the gain from access to low-cost goods. Even for a country like the United Kingdom, which is roughly self-sufficient in oil, the rise in the oil price will still initially redistribute income away from households and non-oil businesses and towards the oil companies and the government. Should workers resist the consequent decline in the purchasing power of their wages, the level of potential supply would be adversely affected.
The second potential effect of globalisation is on the short-run dynamics of the inflation process. One of the most notable developments of the past decade or so has been the apparent flattening ofthe short-run trade-off between inflation and activity. That is particularly obvious in the case of the United Kingdom (Chart 5), but can also be observed in many other countries (e.g. Chart 6 for the United States). As can be seen, the Seventies were characterised by an almost vertical relationship in the United Kingdom, in which any attempt to hold unemployment below its natural rate resulted in rising inflation.
In the Eighties, the downward sloping relationship reappears, as inflation was squeezed out of the system by the slack in the economy. However, since the early Nineties, the relationship looks to have been rather flat. Now in theory, it is possible that this just reflects our extraordinarily precise management of aggregate demand, which has kept unemployment exactly in line with a falling natural rate.
But while macroeconomic policy may have been much better over this period, it defies belief that it was that much better. Instead it looks as if the inflation process itself may have changed in some way. Part of the story probably is connected to the change in policy regime, though in a more subtle fashion.
Inflation targeting appears to have kept inflation expectations well-anchored (Chart 7), whereas in the past falling unemployment might have led to expectations of higher future inflation, adding to the upward pressures on current inflation. Moreover, businesses need to raise prices less frequently to keep up with inflation when its average rate is low, so that increases in demand are less likely to lead to an increase in the overall price level, at least in the short run.
But the structural consequences of globalisation also seem to have flattened the short-run trade-off between inflation and the domestic output gap through a variety of channels. First, the increased trade and specialisation associated with globalisation reduces the response of inflation to the domestic output gap, and at the same time potentially makes it more sensitive to the balance between demand and supply in the rest of the world5.
A recent study carried out at the Bank for International Settlements by Claudio Borio and Andy Filardo finds some empirical support for this proposition across a range of countries. Second, increased competition from labour-abundant economies may reduce the cyclical sensitivity of profit margins, as businesses have less scope to raise their prices when domestic demand increases.
So assuming that marginal costs rise with output, we would expect that the mark-up of price over marginal cost will tend to be squeezed more when demand rises (and vice versa, when it falls). Work carried out at the Bank by former MPC member, Steve Nickell, together with Nicoletta Batini and Brian Jackson7finds that this indeed seems to be the case.
See, for instance: Jordi Gali and Tomasso Monacelli, 2005, “Monetary policy and exchange rate volatility in a small open economy”, Review of Economic Studies, Vol. 72, pp707-734; and Razin, Assaf and Chi-Wa Yuen, 2002, “The‘New Keynesian’ Phillips curve: Closed economy vs. open economy”, Economics Letters, Vol. 75, May, pp.1-9. 6Claudio Borio and Andrew Filardo, 2006, “Globalization and inflation: New cross-country evidence on the globaldeterminants of domestic inflation”, mimeo, Bank for International Settlements, Basle. 7Nicoletta Batini, Brian Jackson, and Stephen Nickell, 2005, “An open economy New Keynesian Phillips curve for the UK”, Journal of Monetary Economics, vol. 52, pp. 1061-1071.
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Third, production costs may also have become less sensitive to the state of the business cycle. The increased ease with which activities can be off-shored to China, India or Eastern Europe will make workers less inclined to push for higher wages when unemployment falls, and stiffen the hand of employers in resisting such claims, so limiting the effect of higher activity on the marginal cost of labour. Moreover, there is an additional factor in the case of the United Kingdom, in the shape of increased inward migration.
Official migration estimates – though it should be emphasised that there is very considerable uncertainty over the true magnitude – together with a reasonable assumption about migrants’ labour force participation suggests that migration probably accounts for around two-thirds of the increase in the workforce since 1997. The size of this flow, particularly from the Accession countries of Eastern Europe, reflects in part the substantial wage differentials between the United Kingdom and the migrants’ home country, but the magnitude of the flow is also likely to vary in line with the tightness of the UK labour market.
And businesses are increasingly used to sourcing their workers from abroad, often through the use of specialised agencies. So if they are finding it difficult to get the additional workers they need, rather than bidding up wages to attract them from other firms, they may instead simply look to get them from abroad.
The migration resulting fromthe increased international mobility of labour therefore represents another force that weakens the link between activity and the cost of labour. These three factors – increased specialisation; the intensification of product market competition;and the impact of that intensified competition and migration on the behaviour of wages – should all work to flatten the short-run trade-off between inflation and domestic activity.
But it is worth mentioning one consequence of globalisation that might work in the opposite direction. An increase in the competitive pressures in product markets will mean that the profits foregone by setting a price at the “wrong” level will be all the greater. That would encourage businesses to revise their prices more frequently, and will tend to steepen, rather than flatten, the trade-off8. That is in the opposite direction from the likely impact of moving to an environment of low inflation that I mentioned earlier. By way of providing some evidence on this, we recently asked our regional Agents to conduct a small survey of some of their business contacts in order to see how the frequency of price changes _____________________________________________________________________ 8See Ken Rogoff, 2003, “Globalization and global disinflation”, in Federal Reserve Bank of Kansas City, Monetary Policy and Uncertainty: Adapting to a Changing Economy, pp.77-112.
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had changed over the past decade. Chart 8 shows the results, broken down by sector9. There is a marked tendency towards an increased frequency of price changes in virtually all sectors, including in manufacturing which is probably the sector most exposed to the effects of globalisation.
The increase in the frequency of price changes in retailing is particularly striking and probably reflects the dramatic intensification of competition in that sector – the “Tesco effect” – as well as the consequences of technological advances that make the fine tuning of prices easier. The extent to which the flattening of the short-run inflation-activity trade-off is down to globalisation, and the extent to which it is associated with the change in monetary regime is ultimately an empirical matter. There are cross-country empirical studies that suggest that it is indeed flatter in more open economies10.
And there are also studies that suggest that the change in the conduct of monetary policy has been important11. So both factors are likely to be at work. Perhaps even more important than the way globalisation has affected the response of inflation to demand is the way that it appears to have altered the response to cost shocks. If you had told the MPC in early 2004 that oil prices would triple over the following two years, I think we would have been very worried indeed about the possible inflationary impact, notwithstanding the fact that it was partly associated with the same globalisation forces that were helping to drive down the prices of imported goods.
While the oil intensity of production today is about half what it was in the Seventies, we would nevertheless have been concerned that the higher cost of energy would lead to so-called second-round effects on wages as workers sought to maintain the purchasing power of their earnings, as well as on to the prices of other goods and services. In the event, pay growth has so far remained remarkably stable (Chart 9). Indeed far from picking up over the past year or so, it has actually eased.
Since consumer price inflation has picked up during that time, the rate of growth of the purchasing power of those wages (the real consumption wage in Chart 10) has slowed and ensured that the real wage in terms of the price of UK output (the real product wage) has grown more or less in line with trend productivity growth. One reason why wage growth may have been so subdued is that unemployment has edged up since early 2005. But that appears not to be the whole story. Exactly the same heightened competitive _____________________________________________________________________ 9The original version of this speech included a somewhat different version of this Chart and contained a calculation error.10See e.g. Joseph Daniels, Farrokh Nourzad and David Vanhoose, 2005, “Openness, central bank independence, and the sacrifice ratio”, Journal of Money, Credit and Banking, Vol. 37(2), April, pp.371-379. 11See e.g. Luca Benati, 2005, “The inflation-targeting framework from an historical perspective”, Bank of England Quarterly Bulletin, Vol. 45(2), Summer, pp.160-168.
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pressures in product markets that appear to have contributed to the flattening of the inflation-activity trade-off, may also have affected the way that businesses have responded to the increase in energy costs. Rather than immediately pass on in full such increases in higher prices, it appears that they may have instead looked to lower other costs, either by granting lower wage increases, or by putting downward pressure on the prices of intermediate inputs, or by raising efficiency.
Our regional Agents have also asked a sample of their business contacts how they have responded to the squeeze in profit margins occasioned by the rise in energy costs. The survey suggested that relatively few businesses expected to be able to raise prices and instead planned to raise efficiency, reduce employment or push down on wage and other costs (Chart 11).
And some respondents felt they had little alternative but to accept the hit on their margins. That was especially the case in manufacturing, which is the sector that is most exposed to international competition. The consequence of this is that, far from seeing second-round effects on wages and other prices as energy costs have risen, if anything they so far seem to have acted as a bit of a cushion.
That is illustrated in Chart 12, which shows the contribution to inflation of the domestic non-energy component of consumer prices for the United Kingdom, United States, the euro area and Canada since 1993 plotted against the contribution of energy and import prices, which can be treated as being largely exogenous to each region. (For clarity and to allow for different average overall inflation rates, the inflation components are presented as deviations from regional averages.) There are clear signs of an inverse correlation in all regions, though the relationship is certainly far fromperfect.
But if this relationship continues to hold in the future, then we might expect the beneficial effect on inflation from the recent fall in oil prices to be partly offset by faster inflation in the non-energy components of consumer price inflation as businesses seek to rebuild their profit margins and workers make up for the squeeze on the purchasing power of their wages. (Some commentators have interpreted this as implying that a rise in oil prices is bad news and a fall in oil prices is also bad news.
That, of course, is nonsense. The presence of a countervailing response of non-energy price inflation to changes in energy price inflation just means that a rise in oil prices is not such bad news for inflation as it first appears, and that a fall in oil prices is not suchgood news as it first appears.) Finally, some brief words on how the changes in inflation dynamics that appear to be down in part to the impact of globalisation might affect the conduct of monetary policy. Clearly the reduced pass-through of energy cost increases into wages and prices is good news for central banks. But the flattening of the inflation-activity trade-off is rather more of a mixed blessing. On the one hand,
Monetary policy is the Key
The case for a top-down approach
By Samuel Brittan
Published: August 2 2007 18:47 | Last updated: August 2 2007 18:47
“The past 15 years have seen inflation settle at low levels throughout the industrialised world. And many countries in the developing world, which had previously experienced high inflation, have seen it falling. If you ask the average business person why this is the case, he or she is almost certain to reply that it is down to cheap imports from the Far East and eastern Europe. Monetary policy probably won’t get a mention.”
These are the words of Charles Bean, the Bank of England’s chief economist, in an article called “Globalisation and Inflation” in the January-March issue of World Economics. Mr Bean is not shy to tackle this version of businessmen’s economics, saying that it is based on a confusion of relative prices with the absolute price level. A flood of cheap imports from newly industrialising countries may temporarily depress inflation. This will leave consumers better off, with more to spend on other products whose prices may then be driven up. Even if this does not happen, “if a country does not fix its exchange rate and is free to pursue an independent monetary policy, it can ultimately always choose its own inflation rate”.
By Samuel Brittan
Published: August 2 2007 18:47 | Last updated: August 2 2007 18:47
“The past 15 years have seen inflation settle at low levels throughout the industrialised world. And many countries in the developing world, which had previously experienced high inflation, have seen it falling. If you ask the average business person why this is the case, he or she is almost certain to reply that it is down to cheap imports from the Far East and eastern Europe. Monetary policy probably won’t get a mention.”
These are the words of Charles Bean, the Bank of England’s chief economist, in an article called “Globalisation and Inflation” in the January-March issue of World Economics. Mr Bean is not shy to tackle this version of businessmen’s economics, saying that it is based on a confusion of relative prices with the absolute price level. A flood of cheap imports from newly industrialising countries may temporarily depress inflation. This will leave consumers better off, with more to spend on other products whose prices may then be driven up. Even if this does not happen, “if a country does not fix its exchange rate and is free to pursue an independent monetary policy, it can ultimately always choose its own inflation rate”.
What Asians learnt from their financial crisis
By Martin Wolf
Published: May 22 2007 19:43 Last updated: May 22 2007 19:43
The Asian financial crisis of 10 years ago taught two contrasting lessons: the one the majority of western economists thought the Asians should learn; and the one Asians did learn.
The western economists concluded that emerging economies should adopt flexible exchange rates and modern, well-regulated and competitive financial markets. The Asians decided to choose competitive exchange rates, export-led growth and huge accumulations of foreign currency reserves. The question is whether the Asians need to change their choice. The answer, I believe, is “yes”.
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When downward pressure on the Thai baht started 10 years ago, nobody expected what followed its devaluation in early July. That seemingly small event generated a financial tsunami that engulfed most of east Asia and overwhelmed Indonesia, Malaysia, the Philippines, South Korea and Thailand. Exchange rates collapsed, financial systems went bankrupt, governments teetered on the edge of default and economies succumbed to deep recessions. Officials from the International Monetary Fund raced from one crisis-hit country to the next. In its last movements, the crisis went global, overwhelming Russia in August 1998 and Brazil in early 1999.
As surprising as the onset of the Asian crisis has been its aftermath. With the important, but geographically limited, exceptions of Argentina and Turkey in 2001, the crises of 1997-98 have so far been the last in the long series of financial crises that afflicted emerging economies in the 1980s and 1990s. Today, the desire of outside investors to put their money in these economies is overwhelming, as is shown in the strength of their financial markets, the low spreads on external borrowing and the size of the private capital inflow: in 2006, for example, net private capital flow to emerging economies was $256bn. The IMF is now almost entirely out of business.
What explains this new stability? As Nouriel Roubini of New York University’s Stern School of Business argues, the Asians did not learn the lessons most western economists thought they should.* This is not to deny that there have been substantial structural improvements in Asian economies, notably in the capitalisation and regulation of financial systems. But this is not the heart of the matter. The big event has been elsewhere: the great mistake, Asian policymakers concluded, was not pegged, but overvalued, exchange rates. That error was what had brought the humiliating dictation by IMF officials operating under the thumb of the US Treasury.
Published: May 22 2007 19:43 Last updated: May 22 2007 19:43
The Asian financial crisis of 10 years ago taught two contrasting lessons: the one the majority of western economists thought the Asians should learn; and the one Asians did learn.
The western economists concluded that emerging economies should adopt flexible exchange rates and modern, well-regulated and competitive financial markets. The Asians decided to choose competitive exchange rates, export-led growth and huge accumulations of foreign currency reserves. The question is whether the Asians need to change their choice. The answer, I believe, is “yes”.
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When downward pressure on the Thai baht started 10 years ago, nobody expected what followed its devaluation in early July. That seemingly small event generated a financial tsunami that engulfed most of east Asia and overwhelmed Indonesia, Malaysia, the Philippines, South Korea and Thailand. Exchange rates collapsed, financial systems went bankrupt, governments teetered on the edge of default and economies succumbed to deep recessions. Officials from the International Monetary Fund raced from one crisis-hit country to the next. In its last movements, the crisis went global, overwhelming Russia in August 1998 and Brazil in early 1999.
As surprising as the onset of the Asian crisis has been its aftermath. With the important, but geographically limited, exceptions of Argentina and Turkey in 2001, the crises of 1997-98 have so far been the last in the long series of financial crises that afflicted emerging economies in the 1980s and 1990s. Today, the desire of outside investors to put their money in these economies is overwhelming, as is shown in the strength of their financial markets, the low spreads on external borrowing and the size of the private capital inflow: in 2006, for example, net private capital flow to emerging economies was $256bn. The IMF is now almost entirely out of business.
What explains this new stability? As Nouriel Roubini of New York University’s Stern School of Business argues, the Asians did not learn the lessons most western economists thought they should.* This is not to deny that there have been substantial structural improvements in Asian economies, notably in the capitalisation and regulation of financial systems. But this is not the heart of the matter. The big event has been elsewhere: the great mistake, Asian policymakers concluded, was not pegged, but overvalued, exchange rates. That error was what had brought the humiliating dictation by IMF officials operating under the thumb of the US Treasury.
“Never again” became the watchword. Never again has been the result. Now the east Asian emerging economies are mostly creditor nations. Moreover, much of their accumulation of external assets is in official hands (see chart). By February of this year, the foreign currency reserves of east and south Asian countries had reached $3,280bn, up by $2,490bn since the beginning of 1999. China’s reserves alone reached $1,160bn, up by $1,010bn over the same period. While a substantial accumulation of reserves seemed a justified (if expensive) form of insurance in the aftermath of the crisis, today’s levels look excessive. In most east Asian economies the ratio of reserves to short-term foreign currency debt is four or five to one.
The scale of the reserve accumulation demonstrates the obvious: these countries have refused to adopt the freely floating exchange rates many outside economists recommended. They have, instead, chosen to keep their exchange rates down. This, in turn, has generated current account surpluses. Sustaining such surpluses requires a stable excess of savings over domestic investment. One instrument they have used has been sterilisation of the monetary consequences of reserve accumulations, to prevent the normal expansion of money and credit, overheating, inflation and so loss of external competitiveness.
If a substantial part of the world economy is generating huge current account surpluses, somebody else has to run offsetting deficits. That conclusion became still more potent when oil prices soared, since this shifted income to countries that painful experience has taught not to spend their additional revenue quickly. In a world of fluctuating currencies, however, accumulating large quantities of net foreign liabilities is easiest for countries able to borrow freely in their own currencies. The reason is simple: only such countries can borrow without risking significant currency mismatches inside their financial systems. It is no accident then that the US has emerged as the world’s chief deficit country – its “borrower of last resort”. It alone is able to be a vast net borrower without risking the health of its financial system.
So is what some economists have called “Bretton Woods Two” – a fixed exchange rate system anchored on the US dollar – both the answer to financial instability in emerging market economies and a basis for sustainable export-led growth?
Mr Roubini argues that it is not. The policy generates ultimately unsterilisable increases in foreign currency reserves. This causes excess monetary growth, domestic asset price bubbles, overheating, inflation and the loss in competitiveness that governments had tried to prevent by suppressing the rises in nominal exchange rates. It distorts domestic financial systems, by pushing interest rates below equilibrium levels. It generates a waste of resources in accumulation of low-yielding foreign currency assets exposed to the likelihood of huge capital losses. It makes Asian economies excessively dependent on demand from outside the region. It exacerbates US protectionism. Finally, it compels US monetary authorities to sustain easy monetary policy, in order to offset the leakage from domestic demand caused by the huge current account deficits.
The post-crisis policy system has proved more durable than many (including myself) expected. At its heart, however, is China. Though not affected directly by the crisis, it was one of the countries that learnt its lessons in the Asian way. Today’s result is a dynamic behemoth accumulating foreign currency reserves at a rate of $50bn a month in the first quarter of the year and expected by the IMF to generate a current account surplus of 10 per cent of gross domestic product this year. I do not believe these astonishing trends are desirable or sustainable. Why that is so and what to do about it I intend to discuss next week.
* Asia is Learning the Wrong Lessons from its 1997-98 Financial Crisis, www.rgemonitor.com/
Economists of the 20th Century
Keynes v Friedman: both can claim victory
By Martin Wolf
John Maynard Keynes, who died in 1946, and Milton Friedman, who died last week, were the most influential economists of the 20th century. Since Friedman spent much of his intellectual energy attacking the legacy of Keynes, it is natural to consider them opposites. Their differences were, indeed, profound. But so was what they shared. More interesting, neither won and neither lost: today’s policy orthodoxies are a synthesis of their two approaches.
Keynes concluded from the great depression that the free market had failed; Friedman decided, instead, that the Federal Reserve had failed. Keynes trusted in discretion for sophisticated mandarins like himself; Friedman believed the only safe government was one bound by tight rules. Keynes thought that capitalism needed to be in fetters; Friedman thought it would behave if left alone.
These differences are self-evident. Yet no less so are the similarities. Both were brilliant journalists, debaters and promoters of their own ideas; both saw the great depression as, at bottom, a crisis of inadequate aggregate demand; both wrote in favour of floating exchange rates and so of fiat (or government-made) money; and both were on the side of freedom in the great ideological struggle of the 20th century.
By Martin Wolf
John Maynard Keynes, who died in 1946, and Milton Friedman, who died last week, were the most influential economists of the 20th century. Since Friedman spent much of his intellectual energy attacking the legacy of Keynes, it is natural to consider them opposites. Their differences were, indeed, profound. But so was what they shared. More interesting, neither won and neither lost: today’s policy orthodoxies are a synthesis of their two approaches.
Keynes concluded from the great depression that the free market had failed; Friedman decided, instead, that the Federal Reserve had failed. Keynes trusted in discretion for sophisticated mandarins like himself; Friedman believed the only safe government was one bound by tight rules. Keynes thought that capitalism needed to be in fetters; Friedman thought it would behave if left alone.
These differences are self-evident. Yet no less so are the similarities. Both were brilliant journalists, debaters and promoters of their own ideas; both saw the great depression as, at bottom, a crisis of inadequate aggregate demand; both wrote in favour of floating exchange rates and so of fiat (or government-made) money; and both were on the side of freedom in the great ideological struggle of the 20th century.
A glimpse of a prosperous 2030
What might the world economy look like in 2030? Nobody knows. But we can consider where present trends are taking us. We can assess, too, some of the dangers and opportunities. That is what the World Bank’s latest Global Economic Prospects report does*. This report does more than help organise our thinking. It should also cheer us up and spur us to do better.
The past quarter of a century has been a time of unprecedented integration of the world economy, as technology advanced and the socialist sandcastles crumbled under the tide of economic liberalisation. As the report also notes: “Global income has doubled since 1980, 450m have been lifted out of extreme poverty since 1990 and life expectancy in developing countries is now 65 on average.”
Globalisation has also proceeded apace: between 1970 and 2004, exports as a proportion of world output doubled to more than 25 per cent; new technologies have diffused rapidly across the globe; and total private financing of developing countries reached nearly $1,000bn in 2004. The persistence of these trends is striking. Moreover, among the encouraging recent features is the acceleration in the growth of incomes per head in the developing world (see chart), as south Asian growth rates and east Asian weights in the total both rose.
So what might the world look like in 2030?
The past quarter of a century has been a time of unprecedented integration of the world economy, as technology advanced and the socialist sandcastles crumbled under the tide of economic liberalisation. As the report also notes: “Global income has doubled since 1980, 450m have been lifted out of extreme poverty since 1990 and life expectancy in developing countries is now 65 on average.”
Globalisation has also proceeded apace: between 1970 and 2004, exports as a proportion of world output doubled to more than 25 per cent; new technologies have diffused rapidly across the globe; and total private financing of developing countries reached nearly $1,000bn in 2004. The persistence of these trends is striking. Moreover, among the encouraging recent features is the acceleration in the growth of incomes per head in the developing world (see chart), as south Asian growth rates and east Asian weights in the total both rose.
So what might the world look like in 2030?
Big questions for global economy in the 21st century
What are the risks to the world economy?
Is the European economy doomed to stagnation?
Do the advanced countries face serious problems of fiscal sustainability?
How should pensions be financed and organised?
Is China's growth sustainable?
These are just a few of the big questions that policy-oriented economists address
Is the European economy doomed to stagnation?
Do the advanced countries face serious problems of fiscal sustainability?
How should pensions be financed and organised?
Is China's growth sustainable?
These are just a few of the big questions that policy-oriented economists address
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