SCHOOLS BRIEF
Bearing the weight of the market
Have the growing international flows of goods, services and money diminished the power of the state? The final brief in our series on global economic integration shows that government is as strong as ever
MOST people in the advanced economies seem willing to accept, most of the time, that economic integration through international flows of trade and finance is a good thing. They acknowledge, for instance, that foreign investment can help poor economies to modernise, and that international competition helps to raise productivity and, at least in the aggregate, incomes as well. Previous briefs in this series have given many examples of these benefits.
Yet people also recognise the costs, such as unemployment or lower wages, that integration may force on particular groups at certain times. When weighing these costs of globalisation against the benefits, economists typically point to the role of government. Through taxes and public spending, they say, societies can use some of the extra income created by globalisation to cushion the losers. In principle, governments could go further, ensuring that everybody ended up better off. Which is very reassuring—unless it turns out that integration itself reduces the freedom of governments to act.
The view that globalisation makes it harder for governments to govern has come to be widely accepted. The basic idea is simple enough. Globalisation adds to the reach and power of the market: now even governments, not just firms and people, must bow down before the new master of worldwide competition.
A government might want to prohibit dangerous or undesirable working practices, for instance. But if it did, the affected industries might move abroad or shut down, because the new regulation could put domestic firms at a disadvantage in competition with foreign producers. Or suppose the government wants to raise taxes and spending. However popular more public spending may be with voters, the market might well forbid it. In the new global economy, people and firms can flee to other tax jurisdictions rather than paying an onerous tax.
Governments do not even have their former freedom to design their own social policies, the argument continues. The financial markets now sit as judge; if they deem that a new national health-care scheme or a massive education reform will prove too costly, they will punish the country with higher interest rates or a collapsing currency. In this way global market forces not only rule out the kind of compensation to losers that would make globalisation easier to live with, they also seem to challenge democracy itself.
If this thinking were correct, there would be good reason to oppose further globalisation, or to regret that the process has gone as far as it has. But it is not correct. In part it is muddled and in part it is simply wrong.
New thinking
During the 1980s, and especially since the collapse of the Soviet empire at the end of the decade, governments have changed the way they think about the role of the state. The failure of communism rattled faith even in far milder forms of socialism.
Governments had also learned from experience: evidence down the years suggested that ambitious economic intervention was often unsuccessful. Politicians in rich and poor countries alike, regardless of whether they were of “the left” or “the right”, began calling for lower taxes and public spending, for lighter regulation of industry, for privatisation of state-owned enterprises, and in general for their economies to be given greater “flexibility”.
In other words, governments have freely chosen to give market forces more sway, in the hope that this will raise living standards. It is odd therefore to say that the global economy has seized power from the state—and it is plain wrong to say that democratic rights have been trampled on.
Many would argue, however, that things are not so simple. Having started to liberalise their economies, governments were left with less power than they had expected. And having surrendered more control than they meant to, politicians found they could not go back. As a result, according to this view, globalsation is running out of control.
Governments themselves have done a lot to foster this idea. Nowadays no statement on economic policy is complete, it seems, without a declaration of impotence which says, in effect, “Our plans reflect not what we would like to do, but what the global market requires us to do.” Advancing technology adds to the sense of helplessness. Things that governments could once forbid or restrict—foreign borrowing; imports of computer software; pornography; political ideas—are now far harder to control because modern communications have eroded the boundaries between nations.
It is true that when technology and liberalisation come together, governments can be taken by surprise. Anomalies appear, sometimes requiring further deregulation, at other times requiring new forms of regulation that previously mattered little. It is also true that governments have sometimes done the right things in the wrong order; liberalising cross-border flows of capital without updating regulation of the banking industry, for example, is one of the factors behind the recent series of financial crises in Asia.
One of the clearest examples of an apparently small measure of deregulation having larger consequences was Britain’s abolition of exchange controls in 1979. This let banks combine foreign capital and new financial technology, and thus compete more vigorously both with each other and with non-bank lenders, such as building societies. Soon, to enable these other lenders to fight back on equal terms, more rules had to be scrapped. This caused new problems—and so the process went on, until the rules that separated banks and building societies had been entirely removed. This inadvertently radical deregulation, and the financial competition it engendered, was instrumental in Britain’s boom and bust of the late 1980s and early 1990s.
Even so, the view that governments today stand helpless before the gale of international market forces is a gross exaggeration. Certainly, it is often a useful idea for governments to take up—what more powerful argument could there be against those opposing any given change of policy than to say “we have no choice”? But, useful as the claim may be, the evidence shows that it is not in fact true.
Like Topsy
The best and simplest measure of a government’s involvement in the economy is public spending. In rich industrial countries this has followed a persistently upward trend since the latter part of the 19th century.
Public spending increased as a share of national income in the 40 years before the first world war, a time when the world economy was arguably more open to trade and international flows of capital than it is today. Between 1918 and 1939, when barriers to trade and capital flows were high, spending as a share of national income rose further. Since the second world war, as economies have once more been opened to the outside world, the trend of rising expenditure has continued (see chart 1). The increase in the economic role of the state has been especially rapid since 1960.
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The answer is partly that taxpayers remain less mobile than one might think. Financial capital, to be sure, now moves instantly from country to country. But once capital has been turned into physical assets such as buildings or equipment, moving it is costly. Governments may grant tax preferences to attract new capital to their countries, but they can continue to tax the profits from physical capital that is already in place.
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Free to borrow
So much for taxes and spending. What about public borrowing and monetary policy? It is often argued that today’s global market for capital applies a particularly severe discipline in these areas. Again, this is misleading. In the first instance, greater mobility of capital gives governments more freedom of manoeuvre in fiscal policy, not less. By borrowing from abroad, they are able to let their spending exceed their revenues by more and for longer than would be possible if their economies were closed to international finance.
Of course, if they abuse this freedom, capital markets will turn against them, and raise the offenders’ cost of borrowing. But this is only like saying that people who run up too big a bank overdraft will be offered poor terms for further loans. The fact remains that an overdraft facility increases financial freedom, it does not reduce it.
Admittedly, living with financial freedom can be more complicated than living without it. In particular, the extreme mobility of modern financial capital makes monetary policy more difficult to conduct. For instance, it has become difficult for governments to peg their exchange rates indefinitely in the face of adverse circumstances. Numerous crises, from the collapse of Europe’s exchange-rate mechanism in 1992-93 to the trauma in East Asia of recent months, make this clear.
The risk of “contagion”, when a crisis in one country leads the market to change its view of prospects in others, is a further complication, as recent events in Asia have emphasised. Nonetheless it remains entirely possible for a government to use monetary policy to steer the domestic economy, provided that it is willing to let its currency float. Today’s global capital market only rules out sooner what has always been impossible in the longer term—namely, treating interest rates and the value of the currency as entirely separate instruments matters. Globalisation has not altered the basic limits: monetary policy can be used to regulate the domestic economy or to regulate the exchange rate, but it cannot successfully accomplish both goals at once.
Finally, what of the argument that the new global economy makes it impossible for governments to mandate social protection, such as minimum-wage laws, rules on working hours, health-and-safety standards in the workplace, and so forth. According to this popular view, if governments grant such protection, they will make their firms uncompetitive and put workers on the dole. Globalisation is thus blamed for a “race to the bottom” in economic regulation.
There is no reason why this should be true. Certainly, social protection does carry economic costs, reducing the amount of output that can be squeezed from any given amount of capital, labour and other resources. This is not to say that social protection is wrong. Citizens may well decide the cost is worth paying. But the cost must be borne. The only question is how.
In an economy closed to flows of trade and finance, the cost will take the form of lower incomes. In an open economy, the same must ultimately be true. This basic logic is the same whether the economy is closed, partially open or globalised. The only difference is that open economies with floating currencies may experience that fall in incomes through currency depreciation—and thus higher prices for consumer goods—while a closed economy will suffer a decline in wages as expressed in the local currency.
The important thing to remember about social-protection rules is simply that, in economics, you rarely get something for nothing. That is the bad news. The good news is that social-protection rules are as feasible, and in the end no more costly, in a globalised economy than they are in a closed economy.
Much the same goes for financial regulation, public spending and macroeconomic policy. Governments, always eager to deflect political pressure, may prefer to justify unpopular decisions by pretending that their hands are tied. In truth, despite all the changes in global markets, they have about as much, or as little, control of their economies as they ever had.
