Globalization and the Current Crisis - Research Paper Example

I. Introduction This paper argues the current global crisis is a direct result of the ongoing globalization. Globalization introduces great opportunities but, at the same time, it also introduces vulnerabilities. Further, globalization is unavoidable but, at the same time, policy can shape the extent and speed of globalization. Countries have the option to moderate the extent and speed of globalization to be consistent with its ability to handle risks. The International Monetary Fund defines globalization as the “increasing integration of economies around the world” (2008, p. 2). Globalization is expressed in the flow of goods, services, and capital across countries (IMF 2008, p. 2). The term “globalization” started to be used more popularly in the 1980s (IMF 2008, p. 2). There are several features of globalization but the most important are the following (IMF 2008, p. 2): 1. Trade as percentage of world GDP increased from 42.1% in 1980 to 62.1% in 2007; 2. Foreign direct investment increased from 6.5% of world GDP to 31.8% in 2006; 3. International claims, primarily bank loans, increased from 10% of world GDP in 1980 to 48% in 2006; and 4. The percentage of foreign workers increased from 2.4% of world population in 1965 to 3.0% in 2005. Differentiating the world’s population into regions and continental divisions, we have figure 1. Figure 1. International trade across regions and continents Source: IMF 2008, p. 2 For the International Monetary Fund, globalization also means that “information and knowledge get dispersed and shared” (2008, p. 2). However, it is important to stress that developments in the globalization process has made the dispersal and sharing of information at a very fast speed. This implies that speculation as we well as transmission of fears, overreaction, both optimism and pessimism, and shaping of expectations takes place at a very fast speed. At the same time, according to the IMF (2008, p. 4), the world’s financial markets “have experienced a dramatic increase in globalization in recent years”. Global capital flows increased from 2% of the world GDP in the 1980s to 14.8% at $7.2 trillion (IMF 2008, p. 4). Developed countries experienced increases that are more dramatic but “developing countries have also become more financially integrated. Just recently, in 2008, the International Monetary Fund reported that academics had been debating on the impacts of globalization and acknowledged that one section of academics saw globalization as injecting dangerous volatility (IMF 2008, p. 4). However, the IMF insisted that financial integration resulted to “unambiguous gains” for advance economies (2008, p. 4). The IMF also emphasized that there are costs in being overly cautious in opening to international capital flows. Further, the IMF also emphasized that emerging economies can gain from financial globalization if they have sound macroeconomics, economies substantially open to trade, and well-developed financial sectors (IMF 2008, p. 4). In contrast with this official perspective of the IMF on globalization, particularly financial globalization, Acting Chief Economist of the IMF for MENA or Middle East and North Africa Auguste Kouame emphasized that the MENA countries have not been highly vulnerable to the ongoing world crisis precisely because of their limited integration with global financial institutions (2009). In 2009, Kouame was expecting the MENA region to grow at 3.3% in 2009 from 5.5% in 2008. At the same time, however, Kouame acknowledged that MENA stock indices dropped by about 50% and that stock indices in the gulf dropped between 30-60% in 2009. Further, Kuoame reported in 2009 that private equities could have dropped by 40% in portfolio value from December 2007 to December 2008. Kouame expected in 2009 that the financial crisis will increases poverty in MENA because a significant number of people are above but close the poverty line: around 5% living on $1.25 a day and 19% living on less than $2 per day. The vulnerability of the MENA countries to the crisis is easily comprehensible based on Figure 1. As we can see in Figure 1, MENA countries have a higher percentage of international goods and services as a percentage of their GDP compared to the advanced countries. What is even suggested by Figure 1, contradicting the position of IMF Chief Economist for MENA Auguste Kuoame, is that MENA would be more vulnerable to the crisis than the advanced or developed countries of the world. As for Asia, World Bank Economic Advisor for the South Asia Region Ejaz Ghani asserted that globalization “accelerated growth in South Asia and contributed to poverty reduction over the last three decades” (WB 2009). However, Ghani euphemistically pointed out that the ongoing global crisis that officially started in 2007 “may potentially change globalization itself, as developed countries adjust to global imbalances that contributed to the crisis” (WB 2009). According to Ghani, three aspects of globalization will not be the same in the immediate future: capital flows, trade flows, and economic management (WB 2009). Ghani pointed out that globalization resulted to a surge in capital flows but the capital flows collapsed in the ongoing crisis and the financial restructuring triggered by the crisis will only allow foreign capital flows to recover after some time (WB 2009). According to Ghani, capital flows will be less accessible in the new risk-averse environment that will emerge with the crisis and the cost of capital will be higher (WB 2009). On foreign trade, Ghani predicted that while globalization led to a large contribution by exports to rapid growth, an export-led recovery is not likely (WB 2009). Ghani pointed out that South Asia is characterized by a high ratio of public debt to GDP (WB 2009). The latter can dampen the efforts of South Asian countries to be more liberal with the globalization process as they might not have ample freedom to use fiscal stimulus should a crisis again re-emerge because of the globalization. II. The literature on globalization The phenomenon of globalization has been studied in the last several years. Friedmann and Goldstein (2004) have recognized at least two disadvantages of globalization. According to Friedman and Goldstein (2004), one disadvantage is that globalization creates a mechanism for the import of shocks from abroad (p. 45). The second disadvantage is that globalization can increase the proportion of credit in foreign currency and local borrowers may not have sufficient hedges against the depreciation of their local currency (p. 45). Karunaratne (2002, p. 3) emphasized that globalization resulted to “hyper mobility of capital and increased the vulnerability of nations to speculative attacks on their currencies”. Further, globalization produces crises contagions and “poses systemic threat to the stability of the global financial system” (Karunaratne 2002, p. 3). On other hand, Sachs (2000, p. 597) had pointed out that “globalization, by itself, hardly guarantee that much of the developing world will be able to achieve rapid economic growth”. On the other hand, Gersbach and Schmutzler (2006, p. 1) pointed out that one advantage of globalization is that globalization promotes skills upgrade in a country’s labor force. Wolf (2002, p. 4) argues that economic troubles happen not because of globalization but because of misguided policies. Meanwhile, the International Monetary Fund has consistently maintained that although the current crisis has jolted the globalization process, “economic and financial globalization and the expansion of world trade have brought substantial benefits to countries around the world” (IMF 2010e). The McKinsey and Company (2010) emphasized that globalization will be unavoidable and will be manifested in the following forms: 1) foreign trade as percentage of GDP will be as high as 37% by 2020, the labor force will be characterized by an internationalization of its composition, the centers of economic activity will continue to be shifting and will be likely located in emerging economies, and labor composition will likely be multi-cultural (p. 4, 17, and 20). Further, most importantly, McKinsey and Company (2010, p. 11) has emphasized that even if globalization will be characterized by crises, there will be “successful innovators” who will profit and become richer from the crises. III. The current crisis: Timeline and key events The world’s economy is projected to grow by about 4.5% in 2010 and 4.25% in 2011 (IMF 2010b, p.1). The 4.5% and 4.25% growth are not bad and can be considered as parts of a non-crisis situation but the IMF believes that downside risks have recently increased and have at recorded in various documents in 2010 that the crisis remains “on-going” (for example, see IMF 2010a and IMF 2010c). Thus, officially, the crisis remains “on-going” even if there is a recovery and a world growth rate of 4.5% and 4.25% are indicated for 2010 and 2011. We note that the IMF (2010b, p.1) reported the, overall, macroeconomic growth indicates steady recovery in many emerging economies and developing economies. However, financial stability suffered a setback as sovereign risks materialized recently (IMF 2010c, p.1). For monitoring risks of a financial crisis, the IMF monitors one indicator known as the composite volatility index and data in July 2010 indicate the composite volatility index has been increasing. This is shown in Figure 2 below: Figure 2. Composite volatility index from January 2009 to July 2010 Source: IMF 2010c, p. 1 In other words, what is indicated by Figure 2 is that the exchange rates, stock markets, and interest rates have been volatile recently, indicating a resurgence of risks in the market despite earlier signs of possible stability. In the words of the IMF (2010d, p. xi), “risks to global financial stability have eased, but stability is not yet assured”. It is widely held by economists all over the world that the current financial crisis began in the US housing market in 2007 (Marshall 2009, p. 1; Nanto 2009, p. 129; Addison et al. 2010; and IMF 2010a). As a result of the crisis in the US housing market, in September and October 2008, the US became a victim of severe financial dislocation characterized by bankruptcies of large financial institutions (Marshall 2009, p. 3). The bankruptcies are “best understood” as a credit crunch that “begun in the summer of 2007 and continued into 2008” (Marshall 2009, p. 3). Yet, at the same time, “the US housing market is seen by many as the root cause of the financial crisis” (Marshall 2009, p. 3). Since the late 1990s, house prices skyrocketed in reaction to several factors including persistently low interest rates, over-generous loans, and speculation (Marshall 2009, p. 3). Using imagery, the rapid growth in house prices has been seen as a rapid growth of a housing bubble that burst simultaneous with the burst in other asset bubbles (Marshall 2009, p. 3). The bursting of the bubbles gave to a credit crisis (Marshall 2009, p. 3). “However, it was the complex web of financial innovations that had been purportedly employed to reduce risks which ensured that that the crisis spread across the financial markets and into the real economy” (Marshall 2009, p. 3). Here Marshall was referring to the linkages of large firms with other firms in the rest of the United States and the linkages of the US firms with other firms outside of the US. For example, if a British firm has invested in the US firm that went bankrupt then the British firm can become bankrupt as the US firm. If these firms are the sources of financing for firms in Latin America, Asia, Africa, and the rest of the world, then the firms in these continents can go down with the US and UK firms. From the United States, the crisis spread through out the world in 2008 (IMF 2010a, p.1). From the perspective of Nanto (2009), however, the root of the crisis can be traced several years back. For Nanto (2009), the overgenerous loans can be traced to how the US responded to earlier crises. In particular, the overgenerous loans can be traced to how the US responded to the recession in 2001. This is indicated in Figure 3. Figure 3. Annualized quarterly actual/projected growth for select countries, 2000-2011 Source: Nanto 2009, p. 138 As what can be seen in Figure 3, nations all over the world went down the drain with the fall of the US economy. This is true, for example, for countries like Mexico, Germany, the United Kingdom, Russia, Japan, South Korea, and Brazil. However, China appear more resilient although affected just the same because of her reputation as an economy least integrated to the world’s economy. Figure 3 indicates one similarity in the sample of countries investigated by Nanto 2009: all economies of the eight countries deteriorated with the US economy as the economy of the latter deteriorated. Figure 4, however, reveals a lot: countries all over the world are correlated and the patterns of economic growth worldwide are the same whether the economy is emerging, developing, or advanced. Figure 4. Real GDP growth: world, advanced, and emerging economies 1970-2015 Source: Addison et al. 2010, p. 2, consolidated from IMF sources Figure 5 confirms the data of Figures 3 and 4 from the perspective of the International Monetary Fund, the world’s multilateral institution and widely considered authoritative on the world economy. Figure 5. IMF on GDP growth of world economies, 2005-2011 Source IMF 2010b, p. 1 In 2010, in a major report with the title, The crisis hits home: Stress-testing households in Europe and Central Asia, the World Bank said that the ongoing crisis since 2007 had adverse effects on the households through the credit market, food and fuel impacts, and income (p. 2). According to the World Bank, the effects are widespread and both poor and nonpoor households have been vulnerable “depending on the economic shock, the specific transmission channel, and selected household characteristics” (WB 2010a, p. xv). The World Bank elaborated that the ongoing crisis from the United States has been translated into a specific macroeconomic shock across various countries and the macroeconomic shock is in turn translated as impacts on incomes, employment, relative prices, and access to credit thereby affecting households (WB 2010a, p. xiv). The macroeconomic itself resulted from global slowdown resulting from falling export demand and “financial deleveraging” by major banks and other financial institutions in developed countries that has reduced the availability and increased the cost of external finance across public, corporate, and financial sectors (WB 2010, p. xiii). According to the World Bank, the ongoing crisis is threatening the welfare of about 160 million people in Europe and Central Asia, 40 million of which are poor and about 120 million are close to the poverty line (2010a, p. xiii). In case of the middle-income countries of the Commonwealth of Independent States (CIS), the crisis that the countries are experiences are threatening to wipe up the gains or recovery they have achieved from the 1998 Russsian crisis (WB 2010a, p. xiii). IV. Analysis of the crisis: Origin, impact, and lessons The world crisis of 2007-2010 “uncovered a fragility in the advanced financial markets that soon led the worst global downturn since the Great Depression” (IMF 2010a, p.1). According to the IMF (2010a, p. 1), “the founders of the Bretton Woods system had taken it for granted that capital flows would never again resume the prominent role they had in the nineteenth and early twentieth centuries”. This implies that, in part, the IMF largely attributes the current crisis to the global movement of capital and to globalization itself. Nanto (2009, p. 132), as illustrated in Figure 6 next page, even asserted that the roots of the current financial crisis can be traced as far back as the Asian Currency Crisis of 1997-1998 and to policies associated with a globalizing world. One measure of globalization is through the so-called 2008 Maastricht globalization index that factors in the political, economic, socio-cultural, technological, and ecological domains of globalization. In investigating the impact of globalization on the GDP, Martens and Amelung (2010, p. 8) found out that the 2008 Maastricht globalization index and real GDP growth rate has a Spearman’s rho correlation of -0.386 that is statistically significant at the 0.05 level in a 2-tailed test. This implies that we can also reject the null hypothesis the correlation between the two variables is zero to accept the alternative hypothesis that globalization (as measured through the Maastricht globalization index) and real GDP growth rate are negatively correlated at the 1-tail 0.05 level. Figure 6. Origin of the global crisis of 2007-2010 Source: Nanto 2009, p. 132 However, the 2008 Maastrich globalization index and employment rate has Spearman’s rho correlation of 0.4464 that is significant at the 0.05 level in a 2-tail test (Martens and Amelung 2010, p. 8). This implies that we can reject the null hypothesis that the Maastricht globalization index and the employment rate is zero to accept the alternative hypothesis that globalization (as measured through the Maastricht globalization index) and employment rate are positively correlated at the 1-tail 0.05 level. The 2008 Maastricht globalization index and inflation has a Spearman’s rho correlation of -0.694 is significant at the 0.01 level in a 2-tail test (Martens and Amelung 2010, p. 8). This implies that we can reject the null hypothesis of zero correlation between the two variables to accept the alternative hypothesis of a negative correlation between globalization (as measured through the Maastricht globalization index) and inflation at the 0.01 level in a 1-tail test. The 2008 Maastricht globalization index and total investment has a Spearman’s rho coefficient of -0.348 but insignificant (Martens and Amelung 2010, p. 8). This implies that we cannot reject the null hypothesis that there is no correlation between globalization (as measured through the Maastricht globalization index) and total investment. Thus, we have no basis to say that globalization affects total investments and vice-versa. Finally, the 2008 Maastrict globalization index and general government debt has a Spearman’s rho correlation coefficient of 0.456 that is significant at the 0.05 level in a 2-tail test (Martens and Amelung 2010, p. 8). This implies that we can reject the null hypothesis that globalization (as measured through the Maastricht globalization index) and general government debt are not correlated to accept the alternative hypothesis that the two variables are positively correlated at the 0.05 level in a 1-tail test. Thus, based on the empirical study of Martens and Amelung, we have a good empirical basis to say that globalization negatively affects GDP growth rate, promotes lower inflation, has a neutral effect on total investments, exacerbates general government debt, and promotes employment. On the other hand, an increasing general government debt promotes vulnerability to crises. The Martens and Amelung (2010) study covered 29 countries of Europe: Ireland, Belgium, Switzerland, Netherlands, France, Austria, United Kingdom, Germany, Denmark, Spain, Italy, Sweden, Estonia, Czech Republic, Norway, Greece, Portugal, Croatia, Slovenia, Hungary, Bulgaria, Poland, Slovakia, Finland, Romania, Turkey, Lithuania, Latvia, and Macedonia. However, according to the World Bank, the key lesson from the current crisis is not about shying away from globalization but bank governance (2010b, p.1). According to the World Bank (2010b, p. 1), the ongoing crisis has emerged because of a failure to observe good principles of bank governance and “behavior prompted by increasingly short-term performance horizons”. For the World Bank, citing confirmatory perspectives and studies from other key institutions, “a lack of effective risk governance tops the list of governance failures leading to the crisis” (WB 2010b, p. 2). For instance, the World Bank said that many boards of banks “lacked a comprehensive understanding of their institutions’ risk profile and were unable to judge its appropriateness” (2010b, p. 2). In turn, according to the World Bank, the lack of understanding of risks among the boards of banks arose from the following (2010b, p. 2): 1. incomplete risk information was being transmitted to the boards; 2. lack of expertise among nonexecutive directors; 3. failure to define the role of boards of banks as one that also involve the identification of strategic risk issues; and 4. overreliance on regulatory and compliance mechanisms in identifying and managing “inappropriate sources of risk”. For the World Bank, the “lack of timely information for the board due to failures in risks system” has been a problem in several major financial institutions and contributed much to the emergence of the ongoing crisis (2010b, p. 1). The World Bank acknowledged that “banks deliberately take and intermediate financial risk to generate revenue” but risk governance require that banks must be able to rapid change their risk profile to ensure that they are able to operate in a sustainable way and avoid a crisis (2010b, p. 1). The World Bank strongly emphasized that if “if there is one lesson from the current crisis -- a lesson consistent with the Asian financial crisis -- is that corporate governance matters” (WB 2010b, p. 7). In reviewing the current or ongoing crisis, the World Bank noted that “the central irony of the governance failures in this crisis is that many took place in some of the most sophisticated banks operating in some of the most developed governance environment in the world” (WB 2010b, p. 7). However, as if the situation confirms that governance rather than globalization was responsible for crisis, the World Bank pointed out that “different financial institutions in those countries fared differently during the crisis, depending in part on the strength of their overall governance framework and culture” (WB 2010b, p. 7). Thus, in addressing the current crisis, for the World Bank, “a key priority is to increase the capacity of boards to oversee strategic risk taking and to accurately judge institutional performance” (2010b, p. 7). Consistent with the World Bank view that bank corporate governance rather than globalization is the culprit for the current crisis, the World Bank pointed out that “improving board capacity will require upgrading the skills, experience, and leadership of nonexecutive directors and rebalancing the productive tension that should come with a high-performing board” (WB 2010b, p. 7). Along this line of though, the World Bank said that shareholders and long-term institutional investors can a positive role towards the avoidance of crises by leading their boards to “focus beyond shorter-term returns that might compromise longer-term safety and soundness” (WB 2010b, p. 7). In addition, government regulators can play a role through mandatory rules for financial institutions as well as through reforms in corporate governance codes (WB 2010b, p. 7). In advancing corporate governance reforms in the financial sector, some issues can be characteristically developed country issues like those related to executive pay while other issues involving “opaque and concentrated ownership” are typically the issues that will be prominent in developing economies (WB 2010b, p. 7). Articulating a divergent tone, Crotty (2009, p. 564) argued that “although the problems in the US subprime mortage market triggered the current financial crisis, its deep cause on the financial side is to be found in the flawed institutions and practices of the current regime, often referred to as the New Financial Architecture (NFA)”. For Crotty (2009, p. 564), the “New Financial Architecture refers to the integration of modern day financial markets with the era’s light government regulation”. Crotty (2009, p. 564) pointed out that “after 1980, accelerated deregulation accompanied by rapid financial innovation stimulated powerful financial booms that always ended in crises”. Crotty (2009, p. 564) criticized that governments responded with bailouts that only allowed expansion to begin that always end up in more complex crises and new bailouts that results into financial crises that have become more threatening. Crotty (2009, p. 564) elaborated that the “NFA is based on a light regulation of commercial banks, even lighter regulation of investment banks and little, if any, regulation of the ‘shadow banking system’---hedge and private equity funds and bank-created Special Investments Vehicles (SIVs)”. According to Crotty (2009, p. 564), “support for lax regulation was reinforced by the central claim of neoclassical financial economics that capital markets price securities correctly with respect to expected risk and return”. Thus, because the expected returns from investing in risks would be positive not negative and, consequently, there would be no crisis, no financial crises, and no crisis that will accompany globalization. According to Crotty (2009, p. 564), the narrative associated with NFA is that “relatively free financial markets minimise the possibility of financial crises and the need for government bailouts”. For Crotty (2009, p. 564), the “scientific foundation of the NFA is shockingly weak and its celebratory narrative is a fairy tale”. Crotty (2009, p. 566) argued that “innovation created important financial products so complex and opaque they could not be priced correctly; they therefore lost liquidity when the boom ended”. Crotty (2009, p. 567) also argued that “the claim that commercial banks distributed all risky assets to capital markets to capital markets and hedged whatever risk remained was false”. According to Crotty (2009, p. 568), under the NFA, the banks have often to keep the riskiest assets because “to reduce moral hazard and convince potential investors that these securities were safe”. V. Globalization and the business administrator and finance professional The foregoing implies that that professional business administrator must be keen on the developments in the global economy. Increasing globalization implies that sources of raw materials and labor may have to be procured overseas, business headquarters may also be located in strategic centers from a global perspective, markets have to identified not only locally but also internationally, and operations may have to be international rather than local. Most importantly, the foregoing discussion emphasized that globalization will have its risk. It may not be an option to stop it completely but it may be possible to slowdown the pace of globalization to be proportionate to the inability of other countries in preventing the export of the crisis as well as to the inability of countries to prevent the import of crisis contagions. In any case, whether we slowdown on or become unable to decelerate the speed of globalization, globalization requires that we sharpen our skills in managing risks and uncertainties. Related to this, finance professionals must be good in the prudential management of their companies and be alert to “inappropriate risks” that their companies are exposed, consistent with some of the prescriptions of the World Bank (2010b). Reference List Addison, T., Arndt, C., and Tarp, F., 2010. The triple crisis and the global aid architecture. Working Paper No. 2010/01. United Nations University: World Institute for Development Economics Research. Crotty, J., 2009. Structural cause of the global financial crisis: A critical assessment of the “new financial architecture”. Cambridge Journal of Economics, 33, 563-580. Friedmann, Y. and Goldstein, I., 2004. Globalization of capital movements: Potential disadvantages and their effect on Israel. Israel Economic Review, 2 (2), 45-78. Gersbach, H. and Schmutzler, A., 2006. The effects of globalization on worker training. IZA Discussion Paper 2403. Bonn: Institute for the Study of Labour (IZA). IMF, 2008. Globalization: A brief overview. 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