Modern Economics Makes Globalization Unnecessarily Complicated

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Globalization, as it is known today, has always been a contentious issue. It may not seem that way for people of my age who grew up under unfettered assumptions. The expansion of global trade as the key vehicle in globalization was accepted as an unqualified good. The rise of previously destitute and economically backward nations throughout the world attributed to the best of Ricardian qualities.

For people younger than me, globalization might seem equally settled if in the other direction. It is now almost a staple of mainstream political discourse, the discontent with what are now believed to be its primary products: labor insecurity and global wage depression.

In the nascent American Republic, Alexander Hamilton produced hisReport on the Subject of Manufacturers to settle the matter in his time. Delivered to Congress in December 1791, the first Treasury Secretary advocated a protectionist stance. Industry in the United States must flourish, he argued, so that Independence could be assured. The very survival of the fledgling nation was not at all guaranteed in those early years.

European nations were subsidizing their own industries. This, among other reasons, Hamilton said American producers “cannot exchange with Europe on equal terms; and the want of reciprocity would render them the victim of a system which should induce them to confine their views to Agriculture and refrain from Manufactures.” An unfair advantage would leave America a nation of only farmers.

None other than George Washington agreed. Not just on the military necessities of what might leave his government to depend too much on foreign production of weapons of war. Unusually fond of beer, our first President was maybe the first to endorse “Made in the USA.” In a letter to Gilbert du Motier, Marquis de Lafayette, Washington informed him in January 1798:

“I use no porter or cheese in my family, but such as is made in America—both those articles may now be purchased of an excellent quality.”

Opposing Hamilton and Washington, Virginia farmer Thomas Jefferson wanted little to do with tariffs and trade restrictions. The South relied on England and France, having little of the industrious spirit of the North. Jefferson wanted completely open trade. Siding instead with Adam Smith whose Wealth of Nations had been published conspicuously in 1776, the idea of free trade seemed only compatible with free society.

Yet, Jefferson would eventually change his mind. The near disaster of the War of 1812 brought home the importance of economic independence as more than an abstract concept. It was Abraham Lincoln, in support of Hamiltonian doctrine, in March 1843 (while still a member of the Whig political party) who endorsed Jefferson’s later reversal.

“He, therefore, who is now against domestic manufactures must be for reducing us either to dependence on that foreign nation, or to be clothed in skins and to live like wild beasts in dens and caverns. I am not one of those; experience has taught me that manufactures are now as necessary to our independence as to our comfort.”

Globalization is nothing new. Perhaps in terms of all human history it is, but increasing trade has been consistent with expansion and social progress. How it is viewed most often depends upon individual circumstances. That’s what makes it such a thorny issue.

To many of the Founders, free trade was political economy rather than strictly economics. Unlike many other debates in economics, globalization may never have left politics.

In his very first column writing for the New York Times, Paul Krugman, an Economist who would eventually win the Nobel Prize from his work on the subject, in January 2000 decried the “sad irony that the cause that has finally awakened the long-dormant American left is that of -- yes! -- denying opportunity to third-world workers.”

“I deliberately say world economy, not American economy. Whatever else they may have been, the 90's were the decade of globalization. Both the bad news (it was a banner decade for financial crises) and the good (living standards in much of the world continued to rise, in some cases -- China -- spectacularly) were closely tied to the ever-increasing integration of national economies with each other, to the seemingly unstoppable logic of growing trade and investment.”

Why was it a banner decade for financial crises? What about the decade which followed? How had China really come to its modern economic miracle?

Most questions were left unanswered as Economists were stuck in the mud of trying to answer everyone’s first question: is globalization worth putting up with the disruptive forces?

As with any grand historical shift, there will be winners and losers. The agrarian American nation of Thomas Jefferson was transformed throughout the 19th century into the industrial powerhouse of the 20th. Farmers and farm workers struggled mightily, by the end of the 1800’s triggering their own counter-globalization populist movement (what William Jennings Bryan was ultimately railing against with his “cross of gold” fever).

What Economists at dawn of the 21st century worked so narrowly to compile was the evidence globalization was net winners over losers, paying so much less attention to where it came from; what it does, rather than what it is. The thought being, so long as there were more winners than losers it would remain, as Dr. Krugman framed it, unstoppable logic.

In June 1999, a novel paper appeared in the American Economic Review (Volume 89) titled Does Trade Cause Growth? Jeffrey Frankel of Harvard’s Kennedy School of Government and David Romer of Berkeley’s Economics Department investigated the potential causal relationship between more trade and more domestic income. Do countries become richer, so to speak, by engaging in more trade?

They uniquely started from a very easy premise: “simply knowing how far a country is from other countries provides considerable information about the amount that it trades.” New Zealand, the initial example they use, because it is geographically isolated the tendency to trade is reduced. The counterexample of Belgium shows that proximity matters a great deal.

Their results are therefore unsurprising. “Distance has a large and overwhelmingly significant negative impact on bilateral trade.” They estimate its elasticity near to -1. Geographic isolation is a key component to trade.

And that can be a problem. The overall findings of the paper, one that has become widely cited, are positive.  

“The results of the experiment are consistent across the samples and specifications we consider: trade raises income. The relation between the geographic component of trade and income suggests that a rise of one percentage point in the ratio of trade to GDP increases income per person by at least one-half percent. Trade appears to raise income by spurring the accumulation of physical and human capital and by increasing output for given levels of capital.”

The statistical results, as Frankel and Romer see it, suggest causation. Rich countries don’t get rich and then buy things from elsewhere. One component of success which makes them rich is robust bilateral, even inter-regional trade.

Apart from the small protests (against the WTO) Paul Krugman was criticizing, this was the accepted view of the nineties. We could see it; China and India were being transformed into modern, economically powerful even necessary states. They had ditched their backwater collectivist schemes and had thoroughly embraced David Ricardo.

The developed world seemed to suffer no consequences. In fact, the US economic boom of that decade spurred by the internet revolution really did appear to be further proof. Globalization was a win-win prospect. Even those on the losing end, those located in rust belts (plural) around the world, they could move to greener pastures just as agrarian workers had done the century before.

No one bothered to ask how it happens. The conventional narrative offers only platitudes. Countries change policies, open their borders and like magic the benefits start accruing immediately. Open markets + open trade = prosperity. Even Communist China could do it.

What’s missing today are the greener pastures. Beginning in 2016, Rust Belt politics went global. Donald Trump wins those key states and shocks Economists (like Paul Krugman) by taking the White House. Before he did, England’s rustier Rust Belt in the North voted overwhelmingly for Brexit. The European Union, perhaps the most visible political expression of globalization, was once incredibly popular but today is a momentous battleground all across the Continent especially where industry once thrived.

A huge part of missing greener pastures is the devastation of global trade. If globalization raises incomes, the constant drag of hardship for it would mean what? Too many on the losing side, not nearly enough winning.

According to the OECD, the total trade in goods last year was just a little less than $25 trillion. That represents a 41% increase from 2007, which only sounds good. Up to 2007, global trade had increased by an average of about 6.8% per year since 1990. Doing some simple math, had trade continued to increase at the same rate after 2007 it would have added up to about $36.5 trillion instead last year.

In other words, the world is about $11.5 trillion short of where it would have been had the trend not been disrupted. Another way of saying that over the last ten to eleven years there have been a whole lot less winners. Twelve trillion is an incomprehensible shortfall.

And it is about to get much, much bigger. Over the last months of 2018, global trade once again is falling apart. More and more key countries are reporting very concerning trade statistics. In Japan, exports shrank by 7% in March 2019 from March 2018. In South Korea, -11% in February. Germany’s six-month average is -3% through February, the lowest since 2016.

This has left many to conclude that President Trump is violating the sacred formula by engaging in trade wars. Yet, the tariffs on Chinese goods are inconsequential compared to the much bigger minuses where they really matter.

The Treasury Department reported this week (TIC) that foreigners have really ramped up their selling of US$ assets. For the month of March 2019, there were foreign purchases of $3.50 trillion balanced against total sales of $3.53 trillion; a net selling of $30.3 billion.

Among those sales, a net $12.5 billion was from foreign official channels. Overseas governments and central banks hold UST’s and the like as “foreign reserves.” The Chinese out of anyone have by far the most.

Also this week, Chinese State media reported that the country’s Communist officials were considering reallocating their reserve stocks. Picked up widely in the context of trade wars, it was spun as a threat to the Americans; keep up the tariffs and we will dump our more than $1 trillion in UST’s and then you’ll regret it.

That may have been the Chinese intended posture for public consumption, but the actual threat is very different. The one being threatened is China and not really all that much by President Trump. By far, the biggest problem and the one that will force them to sell a whole bunch more UST’s in the coming months is global banks.

The Treasury Department’s TIC numbers also contained a truly shocking number. Most people only pay attention to the headline data as I just recited. There is so much more to the set than that, however, including pretty detailed estimates as to what US banks are up to with offshore counterparts.

The level of reported US$ bank liabilities absolutely plummeted in Q1 2019. At -$193 billion, it was the second biggest drawdown in the series history dating back to 1978. The only quarter greater, meaning absolutely worse, was Q1 2009.

This was the very same three months in which, after suffering major market defeats during the fourth quarter of 2018, almost certainly betting on global economic acceleration, several major banks announced significant cutbacks to their FICC operations. Most prominent among them was Credit Suisse, Nomura, and Goldman Sachs. They were not alone.

As former Governor of the PBOC Zhou Xiaochuan wryly observed during that first quarter of 2009, an unstable credit-based global currency system is incompatible with the modern global economy. Without the banks, quite simply, there isn’t the credit-based currency necessary to carry out the vital functions of one.

To some, this is all just one huge, glaring coincidence. The deviation in global trade begins after 2007 when at the same time a massive break in that global currency arrangement plunged the whole world into what was called, wrongly, the Great “Recession.” By what numbers we have available, including broad consistency with trends in real-time market prices, the global monetary system hasn’t recovered, either.

And beginning last year, the rounds were begun anew. The most recent TIC data being an exclamation point on what’s been going wrong for more than a year already. Going back to the fourth quarter of 2017, when all this eurodollar stuff erupted again, banks have reported $328.5 billion less US$ liabilities with offshore counterparts.

A massive funding squeeze. Not just a lot less winners from globalization, a whole bunch more losers.

Economists have always given little thought to the money behind all of it. They talk, again in banalities, about the free flow of capital. By that they mean something very different than what takes place in reality.

Capital doesn’t flow from one place to the next, the eurodollar system fills in the void between all those places so that capital doesn’t really have to flow at all. It is dollars, or eurodollars, that do. It is the middle currency that for Economists might as well be stuck in the middle of nowhere.

But while they ignore it and puzzle over how and why globalization has radically changed, the real world’s real economy tries best to get along with a malfunctioning system; one which could produce what the recent TIC data suggests. It is a direct impediment to global trade and therefore domestic incomes. Economic systems once closely tied to others regardless of geography now find themselves increasingly isolated in money more than distance.

This is the fourth time it has happened over the last eleven almost twelve years, and this fourth funding squeeze is getting larger; as are the minus signs proliferating around the world’s economic accounts. Also this week, US Industrial Production and Retail Sales were reported that way to go along with Chinese Industrial Production near matching a record low and Retail Sales the worst since the late nineties.

The politics are pretty simple. Maybe they always were. It is modern Economics which makes it unnecessarily complicated.  

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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