The Practical Limits of Globalization

What limits does the process of globalization set to economic growth?

May 20, 2004

What limits does the process of globalization set to economic growth?

Global economic integration has advanced at a relentless pace during the past several decades — fueling increases in growth rates and trade in the process. But there are plenty of reasons to question its sustainability. In this Globalist Document, Federal Reserve Board Chairman Alan Greenspan ponders how long the rapid pace of globalization can continue.

Globalization has altered the economic frameworks of both advanced and developing nations in ways that are difficult to fully comprehend.

Nonetheless, the largely unregulated global markets, with some notable exceptions, appear to move effortlessly from one state of equilibrium to another. Adam Smith’s “invisible hand” remains at work on a global scale.

Because of a lowering of trade barriers, deregulation and increased innovation, cross-border trade in recent decades has been expanding at a far faster pace than GDP.

As a result, domestic economies are increasingly exposed to the rigors of international competition and comparative advantage.

In the process, lower prices for some goods and services produced by our trading partners have competitively suppressed domestic price pressures.

Production of traded goods has expanded rapidly in economies with large, low-wage labor forces.

Most prominent are China and India, which over the past decade have partly opened up to market capitalism, and the economies of central and eastern Europe that were freed from central planning by the fall of the Soviet empire.

The consequent significant additions to world production and trade have clearly put downward pressure on domestic prices, though somewhat less so over the past year.

Moreover, the pronounced fall in inflation, virtually worldwide, over the past two decades has doubtless been a key factor in the notable decline in world economic volatility.

Globalization and innovation, far more than in earlier decades, appears to explain the events of the past ten years better than other conceptual constructs.

If this is indeed the case, because there are limits to how far globalization and the speed of innovation can proceed, the current apparent rapid pace of structural shift cannot continue indefinitely.

The pronounced structural shift over the past decade to a far more vigorous competitive world economy than that which existed in earlier postwar decades apparently has been adding significant stimulus to world economic activity.

That stimulus, like that which resulted from similar structural changes in the past, is likely a function of the rate of increase of globalization — and not its level. If so, such impetus would tend to peter out, as we approach the practical limits of globalization.

Full globalization — in which trade and finance are driven solely by risk-adjusted rates of return and risk is indifferent to distance and national borders — will likely never be achieved.

The inherent risk aversion of people — and the home bias implied by that aversion — will limit how far globalization can proceed.

But because so much of our recent experience has little precedent, we cannot fully determine how long the current globalization dynamic will take to play out.

The increasing globalization of the post-war world was fostered at its beginnings by the judgment that burgeoning pre-war protectionism was among the primary causes of the depth of the Great Depression of the 1930s.

As a consequence, trade barriers began to fall after the war. Globalization was enhanced further when the inflation-ridden 1970s provoked a rethinking of the philosophy of economic policy, the roots of which were still planted in the Depression era.

In the United States, that rethinking led to a wave of bipartisan deregulation of transportation, energy and finance. At the same time, there was a growing recognition that inflation impaired economic performance.

Indeed, Group of Seven world leaders at their 1977 Economic Summit identified inflation as a cause of unemployment.

Moreover, monetary policy tightening — and not increased regulation — came to be seen by the end of that decade as the only viable solution to taming inflation.

Of course, the startling recovery of war-ravaged West Germany following Ludwig Erhard’s postwar reforms and Japan’s embrace of global trade were early examples of the policy reevaluation process.

It has taken several decades of experience with markets and competition to foster an unwinding of regulatory rigidities. Today, privatization and deregulation have become almost synonymous with “reform.”

By any number of measures, globalization has expanded markedly in recent decades. Not only has the ratio of international trade in goods and services to world GDP risen inexorably over the past half-century, but a related measure — the extent to which savers reach beyond their national borders to invest in foreign assets — has also risen.

The decline in home bias — or its equivalent, expanding globalization — has apparently enabled the United States to finance and, hence, incur so large a current account deficit.

As a result of these capital flows, the ratio of foreign net claims against U.S. residents to our annual GDP has risen to approximately one-fourth. While some other countries are far more in debt to foreigners, at least relative to their GDPs, they do not face the scale of international financing that we require.

A U.S. current account deficit of 5% or more of GDP would probably not have been readily fundable a half-century ago or perhaps even a couple of decades ago.

The ability to move that much of world saving to the United States in response to relative rates of return almost surely would have been hindered by the far-lesser degree of both globalization and international financial flexibility that existed at the time.

Augmenting the dramatic effect of increased globalization on economic growth — and perhaps, at some times, fostering it — have been the remarkable technological advances of recent decades.

The advent of real-time information systems has enabled managers to organize a workforce without the redundancy required in earlier decades to ensure against the type of human error that technology has now made far less prevalent.

Real-time information — by eliminating much human intervention — has markedly reduced scrappage rates on production lines, lead times on purchases and errors in all forms of recordkeeping.

The long-term path of technology and growth is difficult to discern. Indeed, innovation — by definition — is not forecastable.

All policymakers are struggling to understand global and technological changes that appear to have profoundly altered world economic developments. For most economic participants, these changes appear to have had positive effects on their economic well-being.

But a significant minority, trapped on the adverse side of creative destruction, are suffering. This is an issue that needs to be addressed if globalization is to sustain the necessary public support.

This Globalist Document is adapted from a speech entitled “Globalization and Innovation” by U.S. Federal Reserve Board Chairman Alan Greenspan. The speech was delivered on May 6, 2004, at the Conference on Bank Structure and Competition, sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois. The full text is available at federalreserve.gov.