Rebuilding Macroeconomics – Background Note
2nd June 2017
The current age of globalisation – deeper integration of economic activity across national borders – began after the Bretton Woods era. For most part, it has supported rising prosperity, particularly in large low-income countries. China’s Premier Xi recently emerged as its unlikely champion. As long as prosperity is broadly aligned with other social objectives, such as inclusion, fairness and environmental sustainability, then globalisation is likely to be supported. However, several recent surveys of public opinion have indicated doubts about its efficacy. Western politicians have responded with increasingly nativist agendas, implying globalisation may have gone too far.
Macroeconomists typically approach globalisation in terms of greater market access. More goods and services are available for consumption, budget constraints are loosened by the ability to borrow and lend overseas and access to external asset markets allows greater diversification of risk. Yet the domain of economic policy is primarily the nation state; fiscal and monetary policies operate mostly through the domestic economy. At this simple level, globalisation can be shown to lead to higher standards of living. Economists also have specialised models for specific markets, which can raise challenges to this macroeconomic approach.
Empirical evidence suggests that greater trade is beneficial for output, although the causal link is contentious. The argument that trade is beneficial for welfare is more nuanced. Trade creates winners and losers, and so an overall beneficial outcome requires a compensating mechanism and certain market conditions to be present. Can a government identify the winners and losers, should it compensate and, if so, how should it do so? If labour cannot quickly be re-allocated between sectors of the economy then the costs may be greater than the gains.
One could argue that societies make progress by responding to price changes and trade is no different. On the other hand, if the losses arise from conditions in external markets abiding by different rules this may introduce a distinction between inequality and unfairness. And even if there should be compensation, it is unclear that a temporary fiscal transfer can be targeted effectively. Given that skills are not uniformly distributed within nations and to the extent that people have local attachments, the distributional impact of trade may have wider regional consequences.
Global supply chains have implications for trade policy. Linkages across borders create interdependencies: some may have more strategic (network) importance than others. At which point could some of linkages introduce systemic risk? Supply chains also have implications for currency (monetary) and commercial policy. Should these be included in macroeconomic models?
Cross border financial flows are more controversial than goods and services. Bretton Woods was a system of closed capital accounts, partly in response to repeated financial crises, but also to the constraints on domestic policy making. In macroeconomic models, capital flows are the counterpart to saving and investment decisions, and therefore mostly benign. By increasing the choice of financial assets, globalisation offers the potential for more diversification of risk. Yet despite this benign approach, there is now a considerable weight of evidence suggesting cross border capital is prone to ‘sudden stops’ which can cause financial instability.
There is evidence that cross border flows are pro-cyclical and exacerbate domestic credit cycles and complicate economic management. How can cross border capital and institutions be incorporated in a meaningful sense in macroeconomic models? There have been scores of systemic crises involving cross border capital. Do we need a new approach to incorporate default on foreign debt? The co-movement of international asset markets implies that exchange rates no longer shield countries from external financial conditions. Is there a case for limiting capital flows and how? The dollar retains an anchor role in the global financial system with the Fed ready to provide dollars to friendly countries. What is the role of central banks in offering cross border financial insurance?
Migration is the oldest, smallest and probably the most contentious form of cross border economic integration. Immigration receives little attention in macroeconomics because the beneficial consequences for output and investment are fairly clear, although distributional consequences can be similar as for trade in goods. There has been some recent revival in migration flows in the context of ‘secular stagnation’ theories. More complex models showing greater differences between natives and migrants, and hence greater potential benefits, especially in the area of pensions.
Like trade, migration can raise issues of fairness and even additional concerns about national identity. There are also concerns around the use of public goods and fixed resources such as housing. Should there be more attention paid to the consequences of emigration? Are large scale migrations likely to be something of the new normal? Is there any evidence that immigration increases investment and productivity?
Globalisation means greater connectivity while our measures of activity are defined by national boundaries. National accounts do not reflect cross border supply chains and financial accounts do not describe derivative transactions which characterise cross border transactions. Networks can transmit risks between countries but we currently operate with limited information. The domain of policy making is also the nation state. Globalisation means decision makers can cross borders, for example through global supply chains, the tax base is partially mobile, and borrowers can raise funds in many currencies. Is regulatory coordination possible when governments represent the interests of their domestic constituents? Is the limit of regulatory coordination the limit of globalisation?
With our economic cycle influenced heavily by international forces, what does this mean for inflation, and even fiscal targeting if the measure is significantly influenced by outside forces? Modern trade agreements cover domestic regulation, foreign investor protection, and third party adjudication. To what extent do these agreements undermine concepts of sovereignty and national identity? Does it matter if institutions responsible for overseeing international engagement, such as the WTO, IMF and World Bank, have power structures that lack political legitimacy?