The Importance of International Trade and Foreign Direct Investment - Case Study Example

Evaluate the importance of international trade and Foreign Direct Investment to lift the global economy out of the downturn. The current global economic crisis has been labelled by economists as the worst economic crisis since the Great Depression and the domino effect of the crisis has culminated in the decline of consumer spending, demise of established businesses in key industry sectors and heightened government burden in developed countries (United Nations: 1). Indeed, in the United Nations’ “Global Outlook: Economic Situation and Prospects 2009”, the United Nations comments that “it was never meant to happen again, but the world economy is now mired in a severe financial crisis since the Great Depression” (United Nations, 1). Moreover, the global nature of the economic crisis has not only had a domino impact on national economies, infrastructure and the retail sector; it has also served as a barrier to quick recovery (United Nations, 2). From a UK perspective, the current financial crisis has reiterated the importance of international trade and foreign direct investment (FDI) to the UK economy particularly in the current global economic downturn. Indeed, the fact that the UK is currently struggling in its recovery process is further testament to the UK reliance on FDI and international trade (Almond & Ferner: 58) The focus of this paper is to critically evaluate the importance of international trade and foreign direct investment to the lift the global economy out of the current downturn with specific reference to the UK. It is submitted at the outset that international trade and inward investment from FDI is a fundamental cornerstone of the UK economy as it is imperative to the sustainability of the economic strengths of the UK to compete in an increasingly competitive economy as a result of globalisation (Almond & Ferner 58). This argument is further supported if we consider the rationale for the current financial crisis. It is submitted that the immediate trigger was the collapse of the US housing market as a result of the sub prime market disaster upon which the international banking industry had been lending through following trends in the housing market (Ambachtshee et al: 149). Indeed, the United Nations analysis of the global outlook for 2009 asserts that “in little over a year, the mid-2007 sub-prime mortgage debacle in the United States of America has developed into a global financial crisis and started to move the global economy into a recession” (United Nations 1). Moreover, prior to the sub-prime catastrophe, the significant foreign direct investment in the US and liquidity of the US economy had maintained low interest prices within an artificial national housing bubble (Shiller: 22). Additionally, another part of this was the problem of policy makers not acknowledging the role of the shadow banking system which remained unregulated particularly in the UK (United Nations 1). The credit conditions were easy and fuelled predatory lending, which in turn led to increased debt, over lending and artificial price hikes (Shiller 22). On the other side of the spectrum, the artificial economic paradigm encouraged inward investment into the UK, which has become increasingly reliant on FDI to attract international trade investment flows to the UK economy (Almond & Ferner). However, the resulting economic downturn has impacted the UK with a ripple effect and additionally, at an economic policy level, the ability of government policy initiatives and bank cash injections in the developed countries was unable to avoid the resulting economic crisis (United Nations 1). As a result, refinancing has been impossible and many leading banking institutions have failed and the stock markets collapsed (United Nations 2). Additionally, the UN cites the central challenge of the financial crisis as follows: “Interbank lending in most developed countries has come to a virtual standstill, and the spread between the interest rate on inter-bank loans and treasury bills has surged to the highest level in decades. Retail business and industrial firms are finding it increasingly difficult to obtain credit” (United Nations 1). This is further compounded by the long term implications of debt and rising unemployment levels. As such, this presses the need for international trade and FDI to boost the UK economy and assist in the recovery process out of the current economic downturn. However the central problem is that the UK reliance on FDI and international trade has left gaps in the development of the domestic sector. As such, the UK is now facing an internal trade deficit (Beardshaw & Ross, 625). This is further compounded by the lack of confidence by foreign enterprises in investing in the UK (Seager, 2009). Additionally, in further considering the importance of international trade and FDI to the UK economy and sustainability going forward, it is submitted that an understanding of the macroeconomic rationale for the current financial crisis is imperative. Indeed, the current financial crisis has brought renewed academic attention to macroeconomic theory with some commentators arguing that the traditional paradigm of macroeconomic theory contributed to failures to foresee the current economic crisis (Akerlof & Shiller 167). The underlying basis of macroeconomic theory is the interrelationship between performance and behaviour in decision making regarding national economies along with a consideration of the various determinants of economic activity (Michl 20). A principle macroeconomic model is the dynamic stochastic general equilibrium model, which explains economic growth, business cycles and monetary and fiscal policy, along with consideration of how the economy evolves over time accounting for random shocks (Colander 1) However, in re-evaluating classic macroeconomic theory, Akerlof and Shiller question why the current financial crisis was not foreseen and argue that “we didn’t because we were cowed by an economic theory that has reached a high level of academic consensus” (178). Moreover, they argue that another central factor was the failure to acknowledge that the housing bubble existed and that consideration of human behaviour is important in macroeconomic theory (Akerlof & Shiller 38). To this end, Akerlof and Shiller posit that their central premise pertaining to macroeconomic theory is as follows: “totally absent from conventional macroeconomic theorising: that the economy is affected by variations in the level of trust, by storytelling and human interest, by perceptions of corruption or unfairness, by anger and optimism, by social epidemics causing changes in gut instincts and feelings. Those factors, we firmly believe, are ultimate causes of the boom we saw a few years ago, and the bust we are seeing now” (Akerlof & Schiller 33). Their proposition that macroeconomic policy contributed to the current economic crisis is supported by Ormerod (2009) who posits that macroeconomics has shaped economic policy in the past twenty years. To this end, Ormerod argues that: “it is these ideas which the current crisis has falsified. And it is specifically the way in which the mainstream economics deals with the risk and uncertainty which is at the root of the problems, both for the discipline of economics and economy itself” (www.paulormerod.com/pdf/accsjuly09.pdf). Moreover, if we consider this proposition contextually in relation to the UK economy, it is evident that the globalisation phenomenon has fundamentally altered the traditional business framework (Homann et al xii). Therefore on the one hand the increasingly competitive global environment underlines the importance of international trade to the UK and the ability of the UK to effectively compete within the global business paradigm. However on the other hand, it is arguable that the increased reliance on international trade and FDI to aid UK economic expansion has also been the underlying weakness in the UK economic model in the previous twenty years as evidenced by the UK’s current weakened position in the global economic downturn (Beardshaw & Ross 600). This is proposition is further supported by Ormerod’s critique of the macroeconomic model. The central basis of Ormerod’s critique is supported by reference to Knight’s concept of risk and that this is central to the reason for the contemporary business cycle, as well as the peaks and troughs of the capitalist economic model (www.paulormerod.com/pdf/accsjuly09.pdf). As such, Ormerod opines that modern macroeconomic theory has failed in addressing the concept of risk and uncertainty, which is exemplified by the current economic crisis. This further correlates to the point that a consistent trend in the financial crisis has been the failure to match capital to the commensurate risk (Blundell-Wignall at www.oecd.org/dataoecd). However, the UK’s attraction as a hub for inward investment was rooted in the advantageous conditions projected through this model. For example, the equilibrium economic macroeconomic model is derived from microeconomic assumptions of orthodox economic theory based on rational utility maximisation by consumers and rational value maximisation by firms (Ormerod www.paulormerod.com/pdf/accsjuly09.pdf). Additionally, these assumptions both operate on the basis that they make economic forecasts rationally (Ormerod www.paulormerod.com/pdf/accsjuly09.pdf). Ormerod argues that this is a false assumption as indicated by the GDP growth estimates for 2009 in Figure 1 below. Moreover, Figure 2 addresses the liquidity projections of the banking sector. Figure 1 Source: www.paulormerod.com/pdf/accsjuly09.pdf Figure 2: Source: www.paulormerod.com/pdf/accsjuly09.pdf It is submitted that the lack of liquidity as indicated by Figure 2 is arguably central to financial crisis (Ormerod www.paulormerod.com/pdf/accsjuly09.pdf). For example, in considering the example of UK bank Northern Rock, the central reason it went into financial difficulty was because it couldn’t refinance its loans as a result of the sub prime bubble and Ormerod observes that: “At the height of the crisis, credit markets froze completely because banks simply did not know whether the next institution was solvent or not. In the week of 15 September 2008, capitalism nearly ground to a halt”(www.paulormerod.com/pdf/accsjuly09.pdf). From a macroeconomic perspective, it was the false assumptions of rational pricing upon which the increasing accumulation of loans and debts had been offered that perpetuated the financial crisis. However, it was this very environment that fuelled FDI and contributed to the UK’s increased reliance on international trade and inward investment. However, the lack of equilibrium in the capital/risk ratio led to artificial interest rates and the applicable interest payments did not cover the actual risk on the loans. Moreover, Ormerod posits that a central causal factor for this imbalance was the macroeconomic assumption that the “interest payments receivable exactly covered the risks involved on the loans” led to the assumption that there was no need to tie up capital that could be lent out for a profit and therefore portfolio of loans on this assumption” (Ormerod www.paulormerod.com/pdf/accsjuly09.pdf). Additionally, this imbalance was compounded by the fact that the domino ripple of defaults triggered by the collapse of the US housing bubble was not foreseen. To this end, Ormerod expressly refers to Blanchard’s statement that “history teaches us that benign economic environments often lead to credit booms, and to the creation of marginal assets and the issuance of marginal loans. Borrowers and lenders look at recent historical distributions of returns, and become more optimistic, indeed too optimistic about future returns” (www.paulormerod.com/pdf/accsjuly09.pdf). The complex causal factors contributing to the financial crisis have created a domino ripple effect on a global basis. From a retail industry perspective, businesses have suffered as a result of lack of consumer confidence and limited disposable income caused by rising unemployment rates, which again presses the importance of FDI to boost the struggling retail sector and provide employment opportunities. This is reinforced by the fact that established retail businesses both large and small are suffering from credit and cash flow problems due to the reluctance of banks to lend even to reliable long standing customers (United Nations 1). Whilst recent reports suggest slow signs of growth, overall countries such as the US and the UK have emphasised the point that declarations of an end to the economic crisis remain premature (United Nations 3). In terms of the recovery process, the United Nations observes that governments of developed countries are implementing more comprehensive measures to address a previously unregulated industry and that “the measures have reshaped the previously deregulated financial landscapes; massive public funding was made available to recapitalise banks, with the governments taking partial or full ownership of failed financial institutions and providing blanket guarantees on bank deposits” (United Nations 1). Therefore, FDI and international trade is not only important to the sustainability of the UK economy, it is also imperative in relation to the UK’s recovery in getting out of the economic slump that is now lasting far longer than originally predicted. As highlighted above, the shortcomings of the macroeconomic model upon which the system was based became a significant trigger in the current economic downturn. However, the lack of lending is not only frustrating options for domestic business, it has also caused a significant reduction in the FDI flows to the UK, which perpetuates the cycle of difficult retail conditions and unemployment at national level. For example, Girma and Greenway’s empirical study of FDI in the UK suggests that the presence of foreign firms in a sector raises the productivity of domestic firms (2001). Additionally, Girma and Greenway’s study suggests that foreign firms and international trade in the UK result in higher productivity comparatively with domestic firms with a significant factor being higher salaries. Moreover, Girma and Greenway highlight that FDI is imperative in certain sectors particularly science, technology exploitation and technology sourcing. Moreover, Girma suggests that overall it is the FDI into low tech sectors that have the largest impact on the UK economy. However, notwithstanding the importance of FDI to the UK economy and its economic recovery going forward, the current economic crisis has culminated in a crisis of confidence, which is further impeding UK recovery efforts. For example, Seager suggests that central catalyst was the fall of Lehman Brothers and overall, the last twelve months has resulted in a severe inward investment slump and refers to the investment report of the UN Conference on Trade and Development which demonstrates that “Investment in Britain was hit much harder by the global downturn than almost any other country. It marks a sharp change of fortunes for the UK, which had long liked to boast that it grabs the lions share of foreign investment flowing into the European Union” (Seager 2009). Seager further refers to the comments of UK Trade and Investment trade promotion body spokesman Shaw’s observation that the UK depends on the flexibility afforded by inward investment. However, Shaw asserts that foreign companies do not currently want to invest in a falling pound and an unstable environment (In Seager 2009). Accordingly, the above analysis demonstrates that whilst the previous economic model upon which the UK was able to secure significant FDI was also a significant part of the reason for the current economic downturn. Moreover, Bearshaw and Ross suggest that the UK has significantly relied on FDI and international trade for almost half its food requirements and the raw materials for industry (Bearshaw and Ross 625). However, the dependency is further highlighted by the fact that the recent expansion has culminated in the UK’s domestic manufacturing economy falling leaving a trade imbalance at national level (Bearshaw and Ross 625). Therefore, whilst the current economic situation clearly highlights the importance of international trade and FDI to the UK’s economic recovery, it is submitted that the UK’s reliance on FDI and international trade has left gaps in domestic economic development. This neglect of the national sector has perpetuated the difficulty of the UK in getting out of the recent recession and clearly presses the need for the UK economic policy to achieve a balance between domestic development and reliance on FDI going forward. Bibliography Akerlof, G., & Shiller, R. Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism. Princeton University Press, 2009 Almond, P., & Ferner, A. American Multinationals in Europe. Oxford University Press, 2006 Ambachtshee, K., Beatty, D., & Booth, L. The Finance Crisis and Rescue: What went wrong? Why? What lessons can be learned? University of Toronto Press, 2008 Beardshaw, J., & Ross, A. Economics. Pearson, 2001 Blundell-Wignall, A. The Current Financial Crisis: Causes and Policy Issues. Retrieved from www.oecd.org/dataoecd/47/26/41942872.pdf accessed November 2009 Colander, D. Post Walrasian macroeconomics: beyond the dynamic stochastic general equilibrium model. Cambridge University Press, 2006. Girma, S., & Greenway, D. Who Benefits from Foreign Direct Investment in the UK? Scottish Journal of Political Economy, 2001, pp.119-33. Retrieved at www.ideas.repec.org accessed November 2009. Homann, K., Koslowski, P., & Luetge, C. Globalisation and business ethics Ashgate Publishing, 2007 Michl, T. Macroeconomic Theory: A Short Course. M. E. Sharpe 2002 Ormerod, P. The current crisis and the culpability of Macroeconomic Theory retrieved from www.paulormerod.com/pdf/accsjuly09.pdf accessed November 2009. Seafer, A. Shiller, R. The subprime solution: how today’s global financial crisis happened and what to do about it. Princeton University Press, 2008 Seager, A. Foreign investment in the UK falls by half. 17 September 2009, Retrieved from www.guardian.co.uk/business/2009/sep/17/uk-inward-investment-slump accessed November 2009. United Nations, Global Outlook: Economic Situation and Prospects 2009, United Nations Publications ICTY, 2009 Read More