Friday, October 24, 2014
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The Bumpy Road Ahead

CAMBRIDGE – If stock market and interest-rate spreads are to be believed, America’s economy has seen the worst and may be on its way to a slow recovery. But the troubles for the world economy are just starting. If globalization does not get the fix it needs, economic prospects will be dim for rich and poor countries alike.

The worst that could happen is a return to the 1930’s, when countries put up high trade barriers and retreated into isolationism, to the detriment of all. Fortunately, this is a remote scenario today. But the next worst thing is to assume that a minor patch-up will be enough to render globalization healthy and sustainable. It will take real effort and creativity to repair the deep cracks in globalization revealed by the financial crisis.

First, the good news. The global response to the crisis may not have been stellar, but neither has it been the free-for-all that might have been feared. The G-20 could not agree on coordinated fiscal stimulus or concrete steps towards banking reform. But it did coalesce behind the International Monetary Fund and provided it with additional resources. Despite scores of new protectionist measures around the world since the onset of the financial crisis, the vast majority are nothing to lose sleep over. Globalization has not received a mortal blow – at least not yet.

The real test is yet to come. The problem is that none of globalization’s underlying weaknesses is likely to be adequately addressed under the current agenda. Financial regulation and supervision will surely be strengthened, but they will remain national in character, with little safeguard against cross-border spillover and regulatory arbitrage.

Moreover, the World Trade Organization’s agenda will remain irrelevant and, in any case, deadlocked. China has yet to discover and adopt an alternative growth strategy that does not rely on a large trade surplus. Trade and immigration (legal and illegal), if left unchecked, will continue to exert downward pressure on rich countries’ labor markets. The financial crisis has not helped improve the image of globalization, which has long been deeply unpopular among ordinary voters in most of the world’s advanced countries.

As a result, globalization’s tendency to produce macroeconomic imbalances and financial fragility, its adverse impact on equality and social peace in many countries, and its weak political legitimacy will continue to generate tension and periodic crises. 

Two other developments will greatly aggravate these weaknesses. The first is that the United States and other advanced countries are unlikely to recover their previous economic dynamism even after financial stability is restored. Rich-country households have suffered a momentous loss of wealth (amounting to tens of trillions of US dollars). This implies that consumption growth will remain muted for some time.

With public debt rising very rapidly, and in some countries projected to exceed 100% of GDP, governments will not be in a position to take up the slack. The restructuring of economies away from finance will necessarily take some time. Stagnation rather than growth will be the name of the game.

Second, global leadership is likely to remain in very short supply. The US will be crippled by its high debt, under-performing economy, and discredited economic model. The European Union will be preoccupied with its own internal integration process. And China, where income per person is one-eighth the level of the US (adjusted for purchasing power parity), is simply too poor to become the new hegemony.

History teaches that global economic order is difficult to establish and maintain in the absence of a dominant economic power. The interwar period, which suffered from a similar crisis of leadership, produced not only a collapse of globalization, but a devastating armed conflict on a global scale.

So the stakes in righting the world economy could not be higher. Mismanage the process, and the consequences could be unimaginable.

Unfortunately, many of the solutions on offer are either too timid or demand too much of a global leadership that is in short supply. The conundrum of global reform is that the proposals that go far enough, such as establishing a global financial regulator, are wildly unrealistic, while those that are realistic, such as reform of the IMF, fall far short of what is needed.

What we need is a vision of globalization that is fully cognizant of its limits. We can start with a simple principle: We should strive not for maximum openness in trade and finance, but for levels of openness that leave ample room for the pursuit of domestic social and economic objectives in rich and poor countries alike. In effect, the best way to save globalization is to not push it too far.

Consider a traffic analogy. One way to prevent traffic accidents is to require everyone to drive a similar car, travel at the same speed, and head in the same direction. Another is to enforce some simple rules: don’t drive in the fast lane if going slow, stop at red lights, use a signal before a turn, and so on.

The first approach may maximize the traffic load that can be carried safely, but it fails to take most people where they want to go and is ultimately self-defeating. The second approach allows drivers to make their own choices, even if this means that they will have to slow down or stop on occasion. Similarly, healthy and sustainable globalization should not impose a straitjacket of common rules on everyone.

The financial crisis laid bare the soft underbelly of globalization. It would be a mistake to respond by trying to take globalization to the next level. The economic and political obstacles that block deep integration cannot be wished away by exhortations. It would serve us far better to take these limits into account and scale down our ambitions.

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