On the Threshold of New Mercantilism

13 february 2017

Time to Manage the Global Governance

Hongyul Han is Professor of Economics at Hanyang University, Korea. This article is a shortened version of the paper written for the Valdai International Discussion Club.

Resume: The recession and the absence of global cooperation add instability and fear of protectionism to the global economy. The bleak landscape of the global economy is paradoxically the product of globalization that hauled the previous decades of economic growth.

The world economy enters a new phase of prolonged recession and uncertainty. Over the past half-century, globalization and underpinning international governance such as the WTO have led global economic growth. Since the global financial crisis of 2007-2008, however, the world economy has failed to create new growth engines. There seems no breakthrough in sight. Nevertheless, the international community is no longer capable of creating new global initiatives as major nations are struggling to tackle a variety of socio-economic problems.

The recession and the absence of global cooperation almost automatically add instability and fear of protectionism to the global economy. The bleak landscape of the global economy is paradoxically the product of globalization that hauled the previous decades of economic growth. So, the immediate challenge is how the international economic community manages the new landscape of the world economy in the face of increased uncertainties and lost growth momentum of globalization.

PROLONGED RECESSION; IT’S STRUCTURAL RATHER THAN CYCLICAL

Worldwide recession is here to stay longer than we want. The world economy is failing to recover from almost a decade long recession except for a short period of V-type comeback from the 2007–2008 global financial crisis. The current situation seems to betray the hope that the recession is only a cyclical one rather than a structural one. The world economy witnessed a euro zone crisis, slowing of the Chinese economy and weak demands in newly developing markets in recent years. We tend to believe that the current recession can be explained by these relatively shorter term events. However, we should remind ourselves that these events originate again from the possibly fundamental changes in the world economic structure.

First of all, the rapid “financialization” of the economy must have increased the overall volatility in the global economic system. Major economic regions have experienced, one by one, continual financial crisis over the last few decades. The fragility of the financial markets is not only detrimental to efficient resource allocation but also rapidly spreading across regions, adding uncertainty to international economic activities of trade and investment. We have observed that a financial crisis of a particular country had seriously negative impacts on periphery countries as international investors in center countries quickly adjust international portfolios. The so-called “Wake-up Call Hypothesis” is quite plausible considering the highly integrated international capital market. Developing countries particularly in Asian regions have to accumulate their hard-earned foreign currency through active export. They have to keep a sufficient level of foreign reserves as an insurance policy against the fear of potential financial crisis. Obviously, the insurance policy, otherwise being potentially productive capital, weakens effective demands in the developing world. The overall sluggish demand also comes from more structural changes such as global and domestic income inequality and fast aging of major societies. While these changes seem to be almost perpetual, policy spaces of governments are limited mainly due to the high level of public debt, a record low level of interest rates and a distorted balance of powers between the market and the public sector.

The UN report “World Economic Situation and Prospects 2016” supports the pessimistic expectation presented above. It shows that every country group of different economic development stages has experienced lower economic growth for a decade than before the global financial crisis. While the growth prospects are positive for the year 2016 and beyond, most institutions are downgrading their forecasts recently. Even the positive prospects greatly hinge on uncertain assumptions of rebounding effective demand in the near future particularly in the major emerging markets (for instance, IMF’s World Economic Outlook update of July 2016, after the Brexit Referendum, downgraded 0.1 percent point for the world economic growth in 2017). The gross fixed capital formation in most countries dropped significantly since after the global financial crisis except in a handful of countries like the U.S, Japan, Germany, and France. While the economic rebound is most conspicuous in the U.S, it has not proven to be sufficient enough to boost overall world economic conditions. It seems quite appropriate to put the popular new tag of “New Normal” to the current situation of the world economy.

IS GLOBALIZATION HITTING THE WALL?

The prolonged slowdown of the world economy may be signaling the end of exported growth in the age of globalization since the 1980s. Globalization may have reached a limit in many respects after it has played as growth locomotive of the world economy.

Since the 1980s, the growth rates of world trade have hauled overall economic growth. Recently, the trend seems to have reversed; growth of trade is slower than the economic growth. It is afraid that world trade is settling down in the lower growth trend around three percent while it had maintained growth rates above five percent for the most years in recent decades. The world economy has not experienced such a reversal of trends before. Particularly, the share of capital goods in total imports gradually dropped from 35 percent in 2000 to 30.1 percent in 2014, whereas consumer goods maintained their share of about 30 percent throughout the same period.

The trend is consistent with the stagnant fixed investment. If this trend continues, it would pose a serious challenge to the developing world, particularly the East Asian countries. In the absence of sufficient expansion of world demand, increased economic sizes of export-oriented emerging markets can create a zero-sum game situation among countries adopting export-led growth strategy. The situation may call for a new growth policy space for many countries, and it is highly likely that protectionism would be included in short lists of policy options.

The potentially new trend of trade and economic growth may reflect an intrinsic limit against furthering of globalization. That is, the world economy may be facing the “Globalization Trilemma,” which says it is just impossible that the world can integrate national economies in full, allowing a certain level of sovereignty and democratic relationship at the same time.

Globalization initiatives, popular for a long time, are becoming too costly an option for politicians and policy makers as we have witnessed in the U.S. presidential election process. Therefore, the world economy may have reached the stage at which not only is globalization unable to lead the world economic growth, but also globalization itself can no longer expand its fronts any further. Major countries do not have sufficient political capitals to create a system of international economic cooperation. It is almost impossible for the international community to agree upon any resolution to call for further sacrifice of sovereignty, which is necessary for strengthening international economic governance in order to push forward further globalization.

Recent development of the U.S domestic politics indicates that no country has big enough political capital to take the leadership in creating a mechanism for new global economic governance. Countries seem busy looking inside rather than outside their borders. At this point, the right question must be how the world economic system could effectively manage the hard-earned current platform of economic cooperation including the WTO.

WIDENING GLOBAL AND DOMESTIC INCOME INEQUALITY

In 2015, the IMF reported that the income inequality continued globally. It was quite news that the same observation was released by the IMF itself because it has been the leading organization of the globalization wave for longer than half-century. Now it is natural to receive such reports warning of an aggravated income inequality and blaming globalization at least partially. As follows from an IMF report on the global trend of income inequality during 1990-2012, the situation has aggravated in most major economic regions. For instance, we can find huge increases of GINI indices in China and Russia in which the indices show not only fast increases but also high absolute levels. Major advanced economies in North America and Europe also showed significant growth of inequalities while Europe still has a relatively equal situation of income distribution. We can find some improvement in less developed regions of Africa and Latin America. However, their absolute levels of GINI are still too high and they are the regions still struggling with the basic socio-economic problems of very limited access to education, health and financial services.

While reducing income inequality itself is an important policy objective today, there is growing evidence that it is also an effective way to promote economic growth. A trading partner country with high income inequality generates smaller bilateral trade flows through lower import demands. A more balanced income distribution provides stronger effective demand necessary for stable economic growth considering the disparate marginal propensities to consume of the rich and poor income groups. Also, if a society fails to improve the income distribution, it could face the risk of falling into a vicious cycle of low growth and aggravated income inequality. Following the logic of IMF, it is true that both the technological gap and globalization may be responsible for today’s income inequality.

However, high income inequality again can widen the technology gap between countries and between social groups within a society with accelerated globalization. It is highly likely that the potential benefits of globalization tend to be limited in a relatively smaller group of high income. Globally widening income inequality is an important background for a pessimistic prospect for the future of the world economy.

UNDERSTANDING THE REAL VALUE OF THE WTO

It is no doubt that the launch of the WTO in 1995 was one of the most important achievements of the international community. It has the most comprehensive governance over commercial policies and trading activities with a binding mechanism for dispute settlement. Ironically, however, the birth of the WTO ignited an explosive expansion of regional economic agreements, mostly in the form of Free Trade Agreement (FTA). Principally, regional economic agreements pursue trade and investment liberalization among a few numbers of contracting parties. They are in line with the objectives of the world trading system under the WTO.

However, as the basic mechanism of regional economic agreements is to provide preferences to members in the bloc, they create discriminatory impacts on world trade flows, thus potentially resulting in distortions in resource allocation globally.

Proliferation of regional economic agreements is almost an inevitable result of the development of global economic governance. The highly liberalized world market under the WTO provided a favorable environment for increased international production sharing by not only multinational enterprises but also medium and small-sized fi rms. It is natural that production sharing activities resulted in creating an agglomeration of industrial activities leading to a new regional economic geography. Once the WTO was established, private sectors seemed to find it too costly to pursue UR-type multinational trade negotiation from the cost and benefit perspectives. The WTO is a platform for “markets (exports and imports) for markets” as well as a code of conducts with respect to trade policy measures. The practically failed Doha Development Agenda (DDA) is the proof that the multilateral trading system has reached the point where the marginal benefit of negotiation efforts is much smaller than the expected marginal benefit of further liberalization of the world market. This argument is well supported if we compare the scopes of the DDA and the UR. The latter for the first time in history, introduced service markets and trade related IPRs into the realm of the multilateral trading system. The DDA is, at most, a mere attempt to improve market access achieved during the UR. The private sectors simply do not find any appetite to push for another round of multilateral trade negotiations. It was natural to pursue regional economic agreements as an alternative as they provide more direct and immediate market access for contacting parties.

Of course, despite this argument, the failure of the DDA does not deny the value of the WTO. It is now working more as the manager of the world trade activities and the supervisor of the code of conduct for trade policy than as a marketplace for international trade. The current multilateral trading system is successful enough to manage trade practices without returning to protectionism.

THE DIMINISHING MARGINAL BENEFIT OF REGIONAL TRADING BLOCS

The theory of the New Economic Geography (NEG) explains that the improved market access through globalization (by both multilateral and regional initiatives) prompts agglomeration of industrial activities in major economic regions or regional central economies.

The increasing return to scale is the very first factor behind the asymmetric space distribution of industrial activities. It is advantageous for manufacturing industries in particular to be concentrated rather than dispersed geographically with respect to the benefits of the economies of scale. Secondly, NEG explains monopolistically competitive behavior of businesses when gathered around limited geographical area; businesses tend to rationalize the size of production activities to take advantage of the economies of scale. Also, the formation of an industrial cluster creates a variety of external effects such as the supply of skilled labor, procurement of intermediate goods, and technology spillover. Therefore, regional economic clusters generate gravity to invoke further concentration of industrial activities. Regional economic agreements reinforce agglomeration of industrial activities. NAFTA created a new industrial zone along the U.S.-Mexico border as businesses took advantage of the improved market access to both markets by actively engaging in international production sharing targeting both markets. The distribution of major industrial regions and existing trade agreements clearly overlaps. That is, regional economic agreements are distributed around regions of most active industrial operations in North America (West Сoast regions of the U.S, U.S.-Mexico border),

The European region (EU members and Сentral European countries) and East Asia (China, Korea, Japan, and China-South East Asia border region).

The expansion of regional economic agreements is a natural response of policy makers to pressures from markets; there has been growing demand for regional economic agreements from both regional economic leaders and followers to support international production sharing activities. However, the wave of regional trade blocs after the WTO seems to have reached the final stage. Most of the major trading countries already joined multiple regional trade agreements. More than two hundred regional trading agreements are in force and more agreements were notified to the WTO. The advance of regional trade agreements brought about much broader and deeper integration in addition to the improved market access provided by the multilateral system.

Obviously, it would again reduce marginal benefits from further efforts for establishing additional trading blocs. Regional trade agreements have reduced trade barriers significantly while adding economic and political costs domestically. The recently stumbling Trans-Pacific Partnership (TPP) is the best proof of this. The TPP is a unique attempt by the U.S. to pursue improving market access on a semi-multilateral platform. On the one hand, the initiative is Plan B for a multilateral approach to global integration. The active involvement of the U.S. in the TPP in recent years signaled its pessimistic view on the future role of the multilateral trading system in furthering market access globally as witnessed by the failure of the DDA. On the other hand, the TPP is a grand experiment of whether a semi-multilateral version of regional trade agreements is achievable. It is formally an FTA of a grand scale. The TPP is doomed not because of its large scale but because of the intrinsic political risks posed by furthering globalization. As we have discussed earlier, it is an interesting observation that the recognition of the social costs of further globalization is widespread among the public in the U.S. Considering its political verdict in the U.S. presidential election, it is hardly likely that the U.S. politics would seriously consider the TPP at least during the early years of the new administration. On the European front, the euro zone crisis and the recent Brexit referendum can be interpreted in a similar way, raising the question of whether the EU can continue further integration.

TRANSITION TO NATIONALISTIC APPROACH AND THE FEAR OF PROTECTIONISM

Of course, there is every reason to worry about protectionism in the face of structural changes of the world economy and appearance of nationalistic politics in both the U.S. and Europe. The recently growing fear of protectionism is understandable because the new president of the U.S. is vividly painted as advocating protectionism, seeking national interests over international cooperation. In the European front, Brexit is a ground for protectionism concerns because it makes policymakers believe populations are against further integration of world markets.

However, from the economic point of view, the nationalistic approach is a plausible option to avoid economic and political costs associated with the internationally cooperative approach. Trump’s pressure on China and members of NAFTA and revoking the TPP are signs of policy transition from a cooperative approach to a nationalistic approach. In an effort to appease his constituents, Trump may bring trade cases against China, both under U.S. trade remedy laws and before the WTO. The nationalistic approach is just an attempt to gain national interests with lower economic and political costs. Strictly speaking, the nationalistic approach is to improve market access to targeted countries. At the same time, threats to impose high tariffs are hardly realistic considering the closely integrated production network between the U.S. and targeted countries. The previous attempts in the 1990s to revoke the MFN treatment to China were never realized just because they would harm the interests of a huge number of U.S. investors in China. Also, it is difficult to relate Brexit directly with protectionism per se.

After the referendum, the U.K. made it clear that it would engage in trade negotiations with major trading partners. It is hardly conceivable that the U.K. would want to raise trade barriers against negotiating partners higher than before. On the contrary, Brexit may be a liberal option to avoid the costs of the regulatory system imposed by the EU. Remember that the EU is not just a form of regional economic integration but is a political process to realize “European federalism.” Brexit is another case of a nationalistic approach by conservative politics seeking a smaller government, rather than a manifestation of protectionism.

*  *  *

The fear of protectionism may be somewhat exaggerated. Threats of protectionism are hardly realistic whereas the nationalistic approach could end up with mixed results, sometimes with more liberalized markets. The real worry is that the nationalistic approach would increase trade disputes among trading partners. It would accelerate the recently increasing trend of discriminatory measures by major trading countries under the prolonged recession of the world economy. It is time to recognize what the international community has achieved in this regard—the WTO. The WTO is more competent as the supervisor of the code of conduct for trade policy than as a marketplace for international trade. The current multilateral trading system is successful enough to manage trade practices without returning to protectionism. We have witnessed the value of the WTO as a stabilizer of international trade during the global financial crisis in 2007-2008 when pundits cried out for a possible return of the pre-World War II type of protectionism. Protectionism has never been a serious concern after the crisis largely thanks to the WTO’s operational capacity to bring trade disputes between member economies under the dispute settlement mechanism. Therefore, it is time that the international community be content with the current role of the WTO in defending the world economy from protectionism, instead of blaming it for not being competent enough to materialize more ambitious market liberalization.

The original copy is available at: http://valdaiclub.com/a/valdai-papers/valdai-paper-60-uncertain-world-economy/

} Page 1 of 5