Duncan’s Economic Blog

Globalisation and Second Best Solutions

Posted in Uncategorized by duncanseconomicblog on February 21, 2011

As I’ve made clear on more than one occasion, I strongly disagree with Mervyn King’s views on fiscal policy and his belief that falling real wage are inevitable. I also think he was allowed himself to wander too far into the political debate in the UK – damaging the Bank’s credibility as independent institution.

But on some issues I agree with him, most notably on the need for a substantial reform of the banking system.

FT Alphaville have an excellent summary of a recent paper (only eight pages and worth reading) from the Governor on the question of global imbalances and financial instability.

As they report “it’s really quite heady stuff for a central bank head. There’s a not-so-subtle yearning for Bretton Woods, plus a tacit admission that regulation can only go so far in combating banking crises, which, at their heart, are caused by gluts and greed.”

The key chart is below, showing the strong correlation between international capital mobility and the appearance of banking crisis.

King notes that regulation can only go so far in preventing crises and compares the post war Bretton Woods system to the current international regime: 

[The current system has] also coexisted, on average, with: slower, more volatile, global growth; more frequent downturns; higher inflation and inflation volatility; larger current account imbalances; and more frequent banking crises, currency crises and external defaults. However, to some extent these period-average metrics obscure significant improvements over the current period, with the ‘great moderation’ period post-1990 associated with much better outcomes than those achieved in the 1970s and 1980s. Nevertheless, with the important exception of infl ation, the outcomes achieved during the Bretton Woods period were better than those attained since 1990. While this does not imply causation of course, it does suggest that better outcomes may be possible.

King ends by calling for a ‘grand bargain’ amongst the major economic powers:

What is needed now is a “grand bargain” among the major players in the world economy. A bargain that recognises the benefits of compromise on the real path of economic adjustment in order to avoid the damaging consequences of a move towards protectionism. Exchange rates will have to be part of such a bargain, but they logically follow a higher level agreement on rebalancing and sustaining a high level of world demand.

I fully agree, and have argued previously that a grand bargain (along the lines of Keynes’ proposed International Clearing Union) is what is required to resolve some of the underlying problems in the world macroeconomy.

But what if such a bargain can’t be struck?

Nouriel Roubini has recently written that:

We live in a world where, in theory, global economic and political governance is in the hands of the G-20. In practice, however, there is no global leadership and severe disarray and disagreement among G-20 members about monetary and fiscal policy, exchange rates and global imbalances, climate change, trade, financial stability, the international monetary system, and energy, food and global security. Indeed, the major powers now see these issues as zero-sum games rather than positive-sum games. So ours is, in essence, a G-Zero world.

Paul Mason has listened some of the current flash points in the ongoing “currency wars”:

China versus the USA: in which the US wants China to allow the RMB to rise against the dollar, weakening China’s competitiveness by raising the price of Chinese exports.

There is the USA versus the Emerging Markets: in which the USA’s quantitative easing policy is seen to be exporting inflation, again forcing the currencies of Brazil, South Korea and other export giants to rise against the dollar.

With the Brazilian real up 40% against the dollar in two years Brazil responded to QE2 with
a. A tax on foreign purchases of bonds, designed to suppress the flow of capital in Brazil
b. $40bn of intervention into the spot market for its own currency
c. This month, a ban on short selling of the dollar against the real in Brazil

There is the Euro versus the dollar. Analysts at Goldman Sachs estimated that the entire negative impact of European austerity programmes in 2010 could be offset by a fall in the Euro’s exchange rate to parity with the dollar: to the extent that this does not happen, Europe bears the cost of its own crisis.

Then there is north Europe verus south Europe. The Eurozone is locked into one exchange rate but peripheral Europe has, over a nine year period lost competitiveness against the core industrialised and export-led countries above all Germany. Southern Europe cannot devalue, so it is being forced to impose an internal devaluation by the Eurozone authorities – which means massive austerity, wage cuts and the erosion of welfare state provision.

Then there is Japan versus America. When America did QE, so did Japan – in part justifying the move on the grounds that QE was an act of exchange rate competition.

Finally there is Britain versus the rest of the world. Sterling underwent a 25% devaluation during the Lehman crisis, stabilising at a net 20% fall against the currencies of its main trading partners. In this way Britain has offset the cost of the crisis, avoiding double-digit unemployment but amplifying the impact of the commodity price inflation that has now taken off. (My emphasis)

Last December I wrote that:

I am simply not convinced that a belief in “free trade, global integration and open markets” is the best starting point when considering globalisation. And I’m far from convinced that centre-left policy makers retreating into a more protectionist mode is a major risk. The bigger risk, as I see it, is centre-left policy makers (who like the authors of the IPPR press release remain convinced of the benefits of free trade) reacting to the world as they wish it to be rather than as it is.

Now let me caveat this – my ideal solution to the question of global imbalances would be some form of International Clearing Union (as proposed by Keynes as Bretton Woods), in the spirit of this I thought the Geithner Plan presented at the recent G20 summit was a worthy aim. I agree with Gordon Brown that a Global New Deal focussed on correcting imbalances and creating jobs and, in a first best world, some form of progressive multilateralism is the centre-left’s base response to globalisation.

But we don’t live in a first best world. We live in a world of rising currency and trade tensions. We live in world in which Germany seems unprepared to engage in multilateral action within the Eurozone itself, let alone globally.

Leaving aside the current currency and trade tensions, we live in a world in which the future of globalisation will be shaped more by China than by liberal democracies.

The only thing I’d add to that now is the below quote form Harold James (an eminent international economic and financial historian) taken from his book on the End of Globalization:

Nobody would suggest that the restrictive trade regimes of the 1930s adopted in country after country represented an optimal path. But there is a powerful argument that they represented a viable, and indeed perhaps the only viable, second-best option. When other countries were imposing monetary deflation and restricting their trade, an attempt to preserve incomes by means of protective legislation represented a logical strategy against externally imposed misery.

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6 Responses

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  1. Neil Wilson said, on February 21, 2011 at 1:01 pm

    The bank isn’t an independent institution – it can’t be unless you believe in autocratic rule by a non-elected bureaucracy.

    The solution is not a grand cuddle so beloved by certain sections of the left. That is ridiculous and has no chance of sticking beyond the first crisis any more than the other so called solutions.

    The solution is to export only what is needed to purchase essential imports not priced in your currency and beyond that to import as much real stuff from the rest of the world as you can purchase with your own scrip while concentrating primarily on the domestic market and domestic employment.

    The first mover to that arrangement gets a real standard of living advantage, and other movers would decrease that advantage until finally the fallacy of composition would make sure that nobody gains an advantage. No dodgy international organisations required – just enlightened self interest.

    BTW Sterling’s exchange rate ended up pretty much where it was during the 1990s. It become more expensive during the Brown boom in household sector debt. So the adjustment in prices we are seeing is merely a return to trend. Unfortunately it is a real impact on the UK’s standard of living.

  2. Dave Holden said, on February 21, 2011 at 3:20 pm

    “The solution is to export only what is needed to purchase essential imports not priced in your currency and beyond that to import as much real stuff from the rest of the world as you can purchase with your own scrip while concentrating primarily on the domestic market and domestic employment.”

    Could you elaborate on this because it just went straight over my head (and in of itself sounds like a “grand” scheme which like you I’m highly suspicious of).

  3. [...] This post was mentioned on Twitter by Patrick Osgood, Duncan Weldon. Duncan Weldon said: What if we're in a second best world? My one man war on the centre left's attitude to free trade continues. http://wp.me/pt0AC-lj [...]

  4. Luis Enrique said, on February 22, 2011 at 10:33 am

    Duncan,

    here’s a ‘defense’ of King you might be interested in:

    http://twentycentparadigms.blogspot.com/2011/02/central-bank-independence.html

    I am repeating myself, but I think your opinion of King ought to account for the possibility that when you referred to falling real wages, he was referring to the UK as a whole being poorer in the coming years (terms of trade, less income from City, less borrowing from abroad) rather than asserting the only way out of this mess is for capital income to rise at the expense of labour.

    • duncanseconomicblog said, on February 22, 2011 at 10:38 am

      Thanks for the link.

      To be honest I think CB Governors are political figures. I like this is more acknowledged in the US – we know that Volcker was a registered Democratic, Greenspan and Bernanke registered Republicans. Although notice that all three were reappointed by Presidents of a different party.

      I’d be far happier if we felt we could ask that question in the UK – although if a member of the Treasury Select Committee asked King how he voted I imagine it wouldn’t go down well!

  5. Luis Enrique said, on February 22, 2011 at 10:33 am

    sorry – he not you in above


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