Pendulum Swing from Globalization to Protectionism?

The world economic and financial system has undergone a dramatic transformation since the early 1980s when financial liberalization took hold in the developed world, then swept the developing world by storm. Prior to this mammoth regime switch, the world was tied up in a straight-jacket of socialistic economic policies that came hand in hand with the Bretton-Woods fixed exchange rate accord, which needed strict international government economic co-ordination.

Throughout the 1980s the liberalization phase was accompanied by a lowering in the variability of key macroeconomic variables. This was termed as “The Great Moderation.” However, the lowering of the volatility of the global macro-economy was not connected with a lowering of global stock and market instability. In 1987, there was the October Stock Market Crash, in 1994 there was the global market crisis, in 1997/8 there was the Asian & Emerging Financial Market Crisis, in 2007/8 was the Global Financial Crisis and 2011 the Greek/Euro Crisis. The big question now must be when is the next one? And will it be connected to the current wave of de-globalization or increased protectionism in the world?

We are now at a stage where the pendulum is swinging firmly back to greater regulation, monitoring and socialistic tendencies. Globalization is on the retreat. Recently, the FT released a report highlighting the decrease in international capital flows across frontiers by about 2/3rds across the board, the research being conducted by McKinsey Global Institute. Given that the strength of the concept of globalization has been directly proportional to global capital flows, this reduction gives some idea about the state of globalization today.

The McKinsey Report highlights a collapse in intercountry bank lending, which reflects a movement towards more equity based financing, as well as a narrowing of trade balances which reflects growing trade protectionism. In addition, a ‘schizophrenic’ Trump, in terms of US foreign policy is advocating greater trade protectionism, withdrawal from global climate accords and the Mexican wall – he has also committed the US to greater military intervention around the globe. More recently more troops for Afghanistan and the possibility of military intervention in Venezuela, but this in recent days is proving to be unaffordable. There is currently the threat of a government shutdown in the US.

When did globalization really begin its retreat?

The 1997/8 crisis is worth further scrutiny as in my mind this is when the Moral Hazard sprite escaped from the Genie’s Lamp and became a global pandemic disease. Moral hazard is a scenario where the banker’s always become winners in the global financial system because acting unethically they issue risky loans which they receive big commissions for. When things go wrong the tax-payers have to bail out the banks or else become even worse off via fronting a global economic collapse that was experienced in the 1930s when the banks in America were allowed to fail. Moral hazard is a situation when “heads” the bankers win, “tails” the tax-payers lose.

In 1997, a boutique hedge fund in the US relying heavily on derivative contracts, LTCM Long-term Capital Management, setup by Nobel Prize winners Professors Merton and Scholes went bust. This firm had exposures in the global economy of over a trillion dollars, starting out with $4 billion of investors’ capital. The collapse of LTCM threatened the collapse of the global financial system because of its massive interconnectedness with larger financial institutions. The bail out of LTCM was coupled with the IMF issuing loans with strict conditions to emerging markets. With the 1997/8 crisis, the Moral Hazard Genie was never screwed tightly back in the lamp because Moral Hazard became a major feature of 2007/8 crisis, associated with another dangerous phenomenon ‘Too Big to Fail.’

Indeed, with fewer global banks than before the crisis, the banking industry has become more oligopolistic with the heightening of both moral hazard and the ‘too big to failure’ phenomenon. In addition, the world economy has not undergone the painful process of deleveraging. Central banks around the globe still have a dangerous portfolio of bad loans on their balance sheets that are toxic. QE quantitative easing has distorted the risk-return relationship in all global markets that led to the commodity market collapse in 2015, where global financial institutions, prevented from manipulating the global real estate market, turned their attention to playing commodities.

A spectacular casualty of this was Glencore.

Recently, Senior Economists at the IMF International Monetary Fund detailed the exposure of US banks to the oil industry at TOFS The Oil, Finance and Shipping Symposium 2016, Chatham UK. Indeed, worldwide, exposure of banks to the oil and gas sectors has become a major issue in contemporary times.

In effect, QE is monetary socialism which has encouraged greater moral hazard since 2010. There have been numerous rounds of QE with each round becoming less effective and causing damage to the global economy. It is interesting that the captains of monetary socialism are often the individuals advocating greater liberalization through free market capitalistic reforms.

China has recently tried to thwart the outflow of both portfolio and FDI foreign direct Investment by ineffectively introducing capital controls. This can be perceived as a form of protectionism.

And so globalization is on the retreat, the swing towards socialism and protectionism, despite blips, is unstoppable. Only when moral hazard is expunged from the global financial system, interest rates normalize and the world undergo debt deleveraging will the world economy recover its long-term growth trajectory. It is very hard to unravel the damage already caused by excessive moral hazard, QE and low interest rates without friction igniting a full blown global financial crisis. You cannot have your cake and eat it. Protectionism brings renewed problems of military instability due to nationalism as has been shown in the past. Well established economic theories advocate a misallocation of resources in a protected global trade environment. The management of globalization by predominantly the US, the IMF International Monetary Fund and the World Bank has been very poor. We’ve made our bed. Now we have to lie in it.