MACROECONOMIC MANAGEMENT AND THE CHANGING ‘POLICY MIX’

UBS HSC Online Economics Day

I want to talk to you today about the two “arms” or “instruments” of macroeconomic management – monetary policy and fiscal policy – used by the economic managers to stabilise aggregate demand, to smooth it out as much as possible as the economy moves through the ups and downs of the business cycle. Their goal is to achieve “internal balance” – low inflation and low unemployment – but, like most balancing acts, this combination isn’t easy to achieve and maintain. That’s because the thing that makes it easy to achieve low inflation is a low rate of growth in aggregate demand – GDP – but low growth usually means high or rising unemployment. On the other hand, the thing that makes it easy to achieve low unemployment is a high rate of economic growth, but high growth usually means rising inflation pressure, as the demand for goods and services runs ahead of the economy’s ability to supply those goods and services.

In other words, there is much potential for conflict between the two objectives of macro management, low inflation and low unemployment. They don’t easily fit together, but we do want both of them. So achieving both at the same time is the great challenge the macro managers – the RBA and the elected government, as advised by Treasury – must continually struggle to achieve.

Both policy arms should push in the same direction

In principle, both arms of policy are capable of being used either to speed up demand or slow it down. For instance, if you use monetary policy to lower interest rates, that should encourage borrowing and spending and so strengthen demand. If you use monetary policy to raise interest rates, that should discourage borrowing and spending and so weaken demand. But similarly, if you use fiscal policy to increase government spending and/or cut taxes, that should stimulate demand, whereas if you use fiscal policy to cut government spending and/or increase taxes, that should restrict demand.

Again in principle, at times when the macro managers feel they have a bigger problem with high unemployment than with high inflation, they should have both arms of policy pushing in the same direction: to strengthen demand. At times when the managers feel they have a bigger problem with high inflation than with high unemployment, they should have both arms of policy pushing in the direction of restraining demand. To put it another way, the economic managers will have more trouble achieving internal balance when, for some reason – perhaps political – they have the two arms pushing in opposite directions.

But the two arms have differing strengths and weaknesses

In practice, however, it’s often not that simple. That’s because the two arms have differing sets of strengths and weaknesses. In practice, the managers have found that monetary policy is better at slowing demand than at speeding it up. This is particularly true at times when household debt is very high – as it is at present – meaning that cutting interest rates isn’t very effective in encouraging people to take on even more debt, whereas increasing interest rates is highly effective in limiting people’s ability to keep borrowing and spending. A second reason why monetary policy is less effective in encouraging spending and more effective in discouraging spending is that interest rates in recent years have been so close to zero. There’s been little scope for them to be cut, but much room for them to be increased.

By contrast, fiscal policy is probably better at boosting demand than at slowing demand. This is mainly because the budget is controlled by politicians, who find it a lot easier to increase spending or cut taxes than to cut spending or increase taxes. To put it another way, the things you do to encourage demand are politically popular, whereas the things you do to discourage demand are politically  unpopular, so it makes sense for the encouragement to be done mainly by politicians through the budget, and most of the discouragement to be done by unelected independent bureaucrats through monetary policy.

The ever-changing ‘policy mix’

This brings us to the key decisions the economic managers must make about the relative roles to be played by the two arms at any point in time. Which of the two arms should take the lead, while the other arm plays a subsidiary, supporting role? If monetary policy is better at slowing demand, while fiscal policy is better stimulating demand, which arm plays the leading role will depend on whether, at the time, high inflation or high unemployment is the main problem. As the problem changes, so will the mixture of the two policy arms.

For many years, the “policy mix” was for monetary policy to be the primary policy instrument used to achieve internal balance, with fiscal policy playing a subsidiary supporting role. This worked well when the primary policy problem was seen as high inflation rather than high unemployment.

But when the economic disruption of the pandemic arrived, with its need to lockdown the economy, the policy mix reversed, with fiscal policy becoming the main instrument, and monetary policy playing the supporting role.

Now, however, with the all the fiscal and monetary stimulus having caused the economy to bounce back strongly from the two lockdowns, the economic managers’ greatest need is to ensure the surge in imported inflation doesn’t get built into the price-wage spiral. So inflation has become the big worry and monetary policy has returned to primacy in the policy mix. As well, this year’s budget papers say the government has transitioned to the second phase of its medium-term fiscal strategy which is to “focus on growing the economy in order to stabilise and reduce debt”. So the policy mix has returned to where it was before the arrival of the pandemic.

Now let’s look in more detail at recent developments, first in monetary policy, and then fiscal policy.

Recent developments in monetary policy

Because of the seven successive years of below-trend growth after 2011-12, the Reserve Bank had cut its cash rate from 4.25 pc at the end of 2011, to 0.75 pc at the end of 2019. It’s not hard to see why it kept the official interest rate low and getting lower for so long: the inflation rate had been below its target range; wage growth had been weak, the economy had yet to accelerate and had plenty of unused production capacity.

Then the arrival of the virus led the RBA to cut rates twice in one month, March 2020, lowering the rate to 0.25 pc. Despite its previously expressed reservations, the RBA also joined the US Federal Reserve and other major central banks in engaging in quantitative easing, QE. It announced its intention to buy sufficient second-hand government bonds to ensure the “yield” (interest rate) on three-year bonds was about the same as the cash rate.

In November 2020, the RBA cut the cash rate even further to 0.1 pc, along with the target for three-year government bonds. It announced the further measure of spending $100 billion every six months buying second-hand government bonds with maturities of 5 to 10 years. Note that all the QE measures were intended to lower the interest rates paid by governments and private firms on longer-term borrowing.

In May 2022, following news that the inflation rate had jumped to 5.1 pc, the RBA announced its decision to raise the cash rate by 0.25 pc points to 0.35 pc to “begin withdrawing some of the extraordinary monetary support that was put in place to help the economy during the pandemic”. This would “start the process of normalising monetary conditions” and returning to “business as usual”. Ensuring that inflation returns to target over time “will require a further lift in interest rates over the period ahead”. Note that this will involve the RBA taking its foot off the accelerator, so to speak, not jamming on the brakes. The RBA also announced that, having ended further QE bond purchases in February, it would now move to QT – quantitative tightening – by not “rolling over” (renewing) its bond holdings as they reach maturity.

Recent developments in fiscal policy

At the time of its election in 2013, the Coalition government expressed great concern about the high budget deficit and mounting public debt it inherited, resolving to quickly get on top of both. But the budget didn’t return to balance until 2018-19. Then the pandemic caused the budget’s automatic stabilisers to go into reverse and return the budget to a large deficit. The government’s massive fiscal stimulus has added further to the deficit and public debt.

The budget deficit reached a peak of $134 billion (6.5 pc of GDP) in 2020-21, and is expected to fall to $80 billion (3.5 pc) in 2021-22, then have fallen to $43 billion (1.6 pc) in 2025-26. The budget is projected still to be in a deficit of 0.7 pc of GDP in 2032-33. The gross federal public debt is projected to reach a peak of 44.9 pc of GDP ($1.1 trillion) in June 2025, before beginning a slow decline as a proportion of national income.

With the election over, the government is likely to come under pressure from macro-economists to tighten fiscal policy somewhat and reduce the budget deficit, so as to hasten the decline in the public debt as a proportion of GDP, as well as to help monetary policy return inflation to the target range.

Read more >>

NEW ISSUES IN MACRO MANAGEMENT: public debt, MMT and QE

Talk to virtual Comview conference

As you well know, thanks to a long period of weak economic growth, we hadn’t made any progress in reducing the federal government’s debt arising from the global financial crisis of 2008-09 before the arrival of the huge budget deficits associated with our response to the pandemic. This has left us – and all the other advanced economies – with levels of public debt higher than anything we’ve known since the period after World War II.

Right now, the economy has yet to recover from the protracted lockdowns employed to deal with the Delta variant of the coronavirus, but the econocrats and most other economists are confident the economy will bounce back almost as strongly and quickly as it did following the end of the initial lockdowns last year. It’s important to remember that the strength of these bounce backs owes much to the huge government spending on the JobKeeper wage subsidy scheme, the temporary Job Seeker supplement and various other assistance programs designed to hold the economy together during the government-imposed lockdowns. The huge loss of household income occurring in a normal recession was thus avoided, leaving people well able to resume spending as soon as restrictions were eased. So there’s no reason to regret the huge increase in public debt. It’s important also to make sure your students understand that the government’s explicit spending decisions explain only part of the huge budget deficits incurred. Much of it is explained by the collapse in tax collections and increased number of people on unemployment benefits – that is, by the automatic operation of the budget’s “automatic stabilisers”. That, too, should be seen as a good thing.

In passing, be clear that, contrary to the “policy mix” of the past 30 years, where monetary policy was the primary instrument used for short-term management of demand, with fiscal policy playing a subsidiary role, fiscal policy has now returned to primacy. To quote this year’s budget papers: “with further support from monetary policy limited, fiscal policy will need to continue to play an active role in driving the unemployment rate lower”.

It’s obvious that budget deficits lead to increased government debt, and only a return to budget surpluses will produce a fall in the absolute level of debt. The underlying cash deficit for last financial year, 2020-21, was $134 billion, or 6.5 pc of GDP, well down on what was expected at the time of the budget in May. This left us with a net debt of $590 billion, or 28.6 pc of GDP. We’ll see the latest estimates of this and future years’ deficits and debt in the mid-year budget update in mid-December. But, though all the pandemic-related assistance measures were temporary, meaning the deficit should fall pretty sharply, all the projections we’ve seen to date show no likelihood of the budget returning to surplus in coming years, “on unchanged policies”.

So, how concerned should we be about our post-post-war record level of debt, and what can or should we be doing to reduce it? And what about the argument of the proponents of “modern monetary theory” who say we should be covering the budget deficit not by borrowing from the public but simply by printing money. And finally, what does the RBA’s resort to “quantitative easing” involve, and how does it relate to the MMT debate?

The changed attitude to public debt

 After the big increase in the federal government’s net debt following the Rudd government’s use of considerable fiscal stimulus to stop the global financial crisis of 2008 causing a severe recession, the government’s view was that, in accordance with the “medium-term fiscal strategy” instituted by the Howard government in 1996, the budget should be returned to surplus as soon as reasonably possible after the economy had recovered. The strategy was to “maintain a budget balance on average over the economic cycle”. That is, the budget would be in deficit during the weak years of the cycle, but this would be offset by surpluses during the strong years, leaving a balanced budget on average, and leaving no net addition to the public debt.

The Abbott government promised to quickly eliminate the debt but, instead, the net debt doubled in nominal terms in the period up to the arrival of the pandemic in early 2020. By then, weak economic growth meant it had taken the Coalition six years just to get the budget back to balance.

The (delayed) budget of October 2020 announced a radical change in the government’s medium-term fiscal strategy. It became to “focus on growing the economy in order to stabilise and then reduce gross and net debt as a share of GDP”. That is, there was no goal to get the budget back to surplus – and, hence, no goal to reduce the public debt in nominal (dollar) terms. Rather, the goal was simply to reduce the size of the debt relative to the size of the economy (nominal GDP). In the government’s oft-repeated slogan: “repair the budget by repairing the economy”.

One of the reasons the advanced economies’ recovery from the Great Recession was so weak was that many of them panicked when they saw how much debt they’d run up and, before their recoveries had properly taken hold, they began cutting government spending and increasing taxes in an effort to get their budgets back to balance. This policy of “austerity”, as its critics called it, proved counterproductive. It weakened their economies’ growth and thus limited their success in reducing budget deficits. This is why Treasurer Frydenberg has repeatedly sworn not to “pivot to austerity policies”.

In switching from using budget surpluses to reduce debt in absolute terms to using stronger economic growth to reduce debt in relative terms, the government is adopting a change in concern about public debt that has occurred among leading American academic economists, influenced by the advanced economies’ pre-pandemic experience of “secular stagnation” or being caught in a “low-growth trap”. Weak growth makes “fiscal consolidation” (spending cuts and tax increases) harder and unwise at a time when governments should probably be investing more to offset the weakness in business investment. At the same time, the low-growth trap has produced exceptionally low interest rates, meaning the cost of “servicing” (paying the interest on) the public debt is lower than ever.

The government (and Treasury Secretary Dr Steven Kennedy) have taken up the American academics’ simple formulation that, whatever its absolute size, a stable amount of public debt will fall as a proportion of GDP so long as nominal GDP is growing at an annual rate exceeding the average rate of interest on the debt. The interest rates on Australian government debt have been between 1 and 3 pc, whereas our nominal GDP should be growing on average by 4 to 5 pc [inflation of 2.5pc plus real growth of 2.5pc]. The wider the gap between GDP growth and interest rates, the greater the scope for modest continuing budget deficits while the debt still falls as a proportion of GDP.

Several points can be made to reinforce this argument for being less anxious about the size of our public debt. First, as I’m sure you understand (but need to explain to every year’s bunch of students), the financial constraints that make it reckless for an individual household to have ever-growing debt don’t apply to governments, particularly national governments. In practice, governments mainly roll-over their debts rather than repaying them.

Second, measured relative to GDP, Australia’s public debt remains about half the size of most other advanced economies’ debt. Third, according to calculations by Saul Eslake, our projected interest payments on the federal public debt will be about 1 pc of GDP over the medium term to 2032, much lower than we’ve been used to. In the late 1980s it was above 2.5 pc. That is, there was never a time when we needed to be less anxious about the interest burden.

Even so, some respected economists – such as Productivity Commission chair Michael Brennan and former Treasury secretary Dr Ken Henry – have expressed concern that this more relaxed attitude to debt is too risky. Henry worries that, without efforts to get the budget back to balance and surplus, we will have limited scope to make an adequate response to the next fiscal crisis. Brennan worries people will conclude that debt and deficit no long matter, that “we can afford the next and the next ‘one-off’ rise in debt”.

But the new, more relaxed attitude to debt and deficit has also been attacked from the other direction – that this attitude remains more worried about debt than it needs to be – by proponents of “modern monetary theory”.

Modern monetary theory

MMT is a school of economic thought that’s been around for some decades. Its great proponent in Australia has been Professor Bill Mitchell, of my alma mater, Newcastle University. But it’s had a great push from the best-selling book, The Deficit Myth, by American Professor Stephanie Kelton.

There is nothing new about MMT. As the syllabus says, national governments face a choice of whether the finance their deficits via borrowing from the public or via borrowing from the central bank – that is, covering the deficit with newly created money. As recently as the mid-1980s, early in the term of the Hawke-Keating government, Australia followed other advanced economies in introducing the rule that deficits must be fully funded by borrowing from the public. This was at a time when the advanced economies were still struggling to get inflation under control. And, since the decision about how budget deficits should be funded is one to be made by governments, central bankers argue that MMT is about fiscal policy, not monetary policy.

Even so, there is much truth to the contentions of MMT. Like everyone else, we have a fiat currency, issued by the government and not backed by a quantity of some valuable commodity such as gold. So, in principle, governments are free to decide how many dollars to create. The MMTers remind us that it’s strange for us to have an arrangement where the private banking system (the banks in total, not an individual bank) able to create money, but the government prohibiting itself from doing so.

MMT is also right in rejecting the monetarist notion that printing money is always inflationary – “too much money chasing too few goods”. As economists have long understood. It’s not how much money has been created that matters, it’s the command over “real resources” – land, labour and physical capital – that money buys. Inflation occurs only when the demand for real resources exceeds the supply of real resources. To demonstrate the point, since the GFC the central banks of America, Britain, Europe and Japan have created massive amounts of money, yet inflation rates have stayed low or fallen (until the recent disruptions to supply caused by the pandemic). Inflation has stayed low because the demand for real resources has remained low relative to the supply of real resources.

Inflation is a consequence of demand being stronger than supply. At least since the GFC, the developed world’s problem has been the weakness of demand relative to supply. This does much to explain the new-found attention to MMT. What can be done to strengthen demand? Why shouldn’t the government add to demand by spending on lots of worthy projects and just create the money to cover it? This is the great theoretical truth highlighted by MMT: for as long as demand is running behind supply, anything the government spends can add to demand without causing inflation.

So in theory, MMT is correct. The econocrats’ objection to it is practical rather than theoretical. If you tell our fallible politicians they can spend as much as they like without bothering to borrow until we reach the point where the “output gap” has been eliminated and aggregate demand is running in line with “potential” – that is, the economy has reached full employment of all real resources – how will you get them to resume covering their spending by borrowing once that point has been reached? Even before you reach that point, how will you get fallible politicians to worry about stopping government spending that wastes real resources when government spending seems like a free lunch? This is what explains RBA governor Dr Philip Lowe’s vehement rejection of MMT. He sees himself responsible for achieving non-inflationary growth. He doesn’t want a new system in which the politicians tell him how much money they want him to create.

Quantitative easing

Short-term interest rates in the US and the other major advanced economies had got to very low levels before the global financial crisis of 2008 precipitated the Great Recession of 2008-09. The US Federal Reserve needed to cut its policy interest rate (the Fed funds rate) a long way to apply sufficient monetary policy stimulus, but was already close to the “zero lower bound”. So it resorted to “unconventional measures”. It intervened directly into particular financial markets that had frozen to get them trading again, and extended its conventional measures, of only influencing short-term interest rates, to lowering longer-term interest rates further out along the maturity “yield curve”. This is “quantitative easing”. Similar to conventional monetary policy, you buy longer-dated second-hand bonds, which forces up their price and so reduces their “yield” (interest rate). Since government bonds set the “risk-free” base on which private sector lending rates are set, this lowers the rates paid by people borrowing for longer fixed-rate periods. The central bank pays for the bonds it buys simply by crediting the accounts of the banks it buys from. That is, it creates the money out of thin air. Once the Fed adopted QE it was soon joined by the Europeans, Brits and Japanese.

It’s not clear that QE does much to encourage borrowing for consumption of goods and services or for business investment, rather than borrowing to buy assets such as houses and shares. But it is clear that the extra outflow of created dollars lowers the country’s exchange rate relative to the currencies of other countries. This lower exchange rate does stimulate the economy of the country engaging in QE by improving the international price competitiveness of its export and import-competing industries. This, however, adds to the reasons the other big advanced economies lost little time in also resorting to QE: so that their exchange rates wouldn’t appreciate against the US dollar.

In principle, once their economies had recovered from the Great Recession the Fed and other big central banks should have stopped buying second-hand bonds and started selling the bonds they’d bought back into the market, thus pushing rates back up to where they had been. It didn’t really happen. Rather, interest rates were still exceptionally low when the pandemic arrived. The Fed and the others leapt into another round of QE.

In Australia, the success of our efforts to avoid being sucked into the Great Recession, and our policy interest rate being a fair bit higher than those of the major advanced economies, meant we didn’t engage in QE at that time. It seems clear that Lowe had his doubts about the effectiveness of QE. But once the severity of the pandemic became clear in late March last year, the RBA cut the cash rate to 0.25 pc (and, in November, to 0.10 pc) and engaged in QE. It guaranteed that it would buy as many bonds as needed to keep the yield on three-year government bonds at the same rate as the cash rate. This was design to assure the financial markets that the cash rate wouldn’t be increased for at least the next three years. This was intended to encourage people to take advantage of the low, emergency-level interest rates. It also had the effect of encouraging the banks to offer very low fixed-rate home loans.

From November 2020, the RBA also announced it would buy $100 billion worth of second-hand federal and state government bonds with maturities of five to 10 years, at the rate of $5 billion a week. This was intended to lower interest rates further out along the yield curve. When the $100 billion had been spent in February this year, the RBA announced it would spend a further $100 billion, although it later decided to cut the rate at which it was buying bonds to $4 billion a week. Early this November, the RBA decided to discontinue limiting to 0.1 pc the yield on the Australian government bond maturing in April 3024. This made it possible for the RBA to decide to increase the cash rate in 2023, even though its forecast still suggested no increase would be needed before 2024.

Purchases of $200 billion worth of second-hand bonds represent about 20 pc of the total stock of federal public debt, meaning the RBA’s purchases of second-hand bonds would be about as much as the government’s issue of new bonds to cover the huge budget deficits it’s been running since the arrival of the pandemic. As part of QE, the cost of the RBA’s bond purchases has been covered merely by creating money, of course. So, despite Lowe’s vehement rejection of the MMT argument that the government fund its deficits by creating money rather than borrowing from the public, his QE has achieved essentially the same effect. The government will have to pay the RBA interest on the bonds the central bank has bought – and in due course, redeem the bonds when their term expires – but, since the government owns its central bank, this will just be a book entry inside the federal public sector. But though you and I can say MMT and QE amount to the same thing, Lowe would insist they are very different. How? MMT means the decisions about how much money to create are made by the fallible politicians, QE leaves the decisions about money creation in the hands of the independent central bankers. So the MMT advocates have had a qualified win.

Read more >>

THE GLOBAL ECONOMY

Aurora College Economics HSC Study Day, Sydney

Every year there’s some event in the news that’s relevant to your study of the global economy, and this year’s is the continuation of the biggest ever: the pandemic entering its second year. A pandemic is a global event by definition, and this pandemic has had big implications for global economic growth and for the future of the globalisation push. There’s nothing new about epidemics starting in one country then spreading to many other countries. It’s been happening for millennia. Even so, it’s the world’s worst pandemic since the “Spanish” flu epidemic immediately after World War I, and the first where the greater economic integration of the world’s countries – and particularly, the huge number of people at any time flying around the world on jumbo jets – caused the virus to reach all corners of the world in a few weeks rather than years. We’ll discuss aspects of the pandemic before discussing a problem special to our economy: the trade sanctions imposed on us by China.

The pandemic

Most governments have responded to the pandemic by restricting people’s ability to cross their international borders, and our government has imposed more comprehensive restrictions than most, greatly disrupting our airlines, inbound tourism industry and universities’ export earnings from overseas students. Like other governments, ours acted to limit the spread of the virus by locking down much of the economy for some time. This caused the world economy to plunge into a deep recession, which governments sought counter by applying considerable fiscal stimulus. We have been more successful than most at suppressing the virus and so were soon able to lift the lockdown. So, although our coronacession was the deepest recession since World War II, it was also the shortest, with the economy taking only about three quarters to rebound to where it was before virus arrived. The recovery will be much slower in most other countries. In Australia, the main issue is how long it will take to vaccinate enough of our population so we can safely re-open our borders.

The end of hyperglobalisation

The pandemic has greatly disrupted international trade and thus confirmed that the period of “hyperglobalisation” has ended. One measure of the extent of globalisation is the growth in two-way trade between countries (exports plus imports) as a proportion of gross world product (world GDP). Between 1990 and 2008, global trade rose from 39 pc to 61 pc of GWP – the period of rapid globalisation. But the proportion fell after the global financial crisis, and even by 2019 had not regained its peak in 2008. The absolute level of world trade is expected to have fallen 9 pc in 2020.

It’s worth noting that the poor countries did well out of the quarter-century of rapid globalisation. Between 1995 and 2019, real GDP per person in the emerging economies more than doubled, whereas in the advanced economies it grew by only 44 pc (after allowing for differences in purchasing power).

The temptation of returning to protectionism

Much of the strong global economic growth during the period of hyperglobalisation can be attributed to increased trade in goods and services between the developed and developing countries. But it’s likely that, in the period of slower growth that has followed the global financial crisis, some countries have yielded to the temptation to return to protecting their domestic industries against foreign competition, returning to the (failed) strategy of growth through “import replacement” rather than “export-led” growth. Regrettably, this trend is being led by the two biggest developing economies, China and India.

The Economist magazine reports that during the pandemic, countries have passed more than 140 special trade restrictions. Some of these may arise from concerns in the rich countries over the lack of availability of personal protective equipment, or vaccines. Worries about the pandemic’s disruption of global supply chains may be another reason for the return of protectionist attitudes in the advanced economies.

 China’s trade sanctions against Australia

Australia’s deteriorating relations with China – which could have been handled much more skilfully by our own government – have led it to impose a succession of sanctions, including very high tariffs and non-tariff barriers, against our exports of barley, beef, coal, copper, cotton, seafood, sugar, timber and wine. Together, these exports were worth about $25 billion in 2019, or 1.3 pc of our GDP.

This is an unfortunate development. Our government will challenge the legality of some of these measures at the World Trade Organisation. But two points are worth noting. First, any loss of export earnings from China caused by these sanctions has been far more than offset by the exceptionally high prices China is paying for our exports of iron ore. Second, estimates by the Lowe Institute suggest that our exporters of most of those sanctioned products have been able to find other overseas markets for them.

Definition

The OECD defines globalisation as “the economic integration of different countries through growing freedom of movement across national borders of goods, services, capital, ideas and people”.

That’s a good definition, but I like my own: globalisation is the process by which the natural and government-created barriers between national economies are being broken down.

A process

With this definition I’m trying to make a few points. The first is that globalisation is a process, not a set state of being. Because it’s a process, it can go forward – the world can become more globalised – or it can go backwards, as national governments, under pressure from their electorates, seek to stop or even reverse the process of economic integration. This is just what Donald Trump promised to do in the US presidential election in 2016.

Among the advocates of globalisation there has tended to be an assumption that the process of ever greater integration is inevitable and inexorable. That was always a mistaken notion, but this has become more obvious since Brexit and the amazing exploits of Trump. First, the British have voted to reduce their degree of economic integration with the rest of Europe – a decision most outsiders see as involving a significant economic cost to the Brits’ economy. Second, the Trump Administration has withdrawn from the Trans Pacific Partnership, an agreement between the US and 11 other selected countries (including Australia) to reduce barriers to trade between them – although the remaining 11 have finalised the agreement without the US.  Third, the Trump Administration has withdrawn from the Paris global agreement on reducing greenhouse gas emissions. Fourth, Trump has launched a trade war with China. President Biden will re-join the Paris agreement and repair America’s relations with its allies, but continue the contest with China.

Earlier globalisation

The point is that the process of globalisation is and always was reversible. People should know this because this isn’t the first time the process of globalisation has occurred and then been rolled back. The decades leading up to World War I saw reduced barriers and greatly increased flows of goods, funds and people between the old world of Europe and the new world of America, Australia and other countries. But this integration was brought to a halt in 1914 by the onset of a world war. And the period of beggar-thy-neighbour increases in trade protection, to which countries resorted in response to the Great Depression of the early 1930s, greatly increased the barriers between national economies. Indeed, you can see that, in the years after World War II, the many rounds of multilateral tariff reductions brought about under the GATT – the General Agreement on Tariffs and Trade, which has since turned into the World Trade Organisation – were intended to dismantle all the barriers to trade built up in the period between the wars.

The channels of globalisation

The four main economic channels through which the world’s economies have become more integrated are:

1) Trade in goods and services

2) Finance and investment

3) Labour

4) Information, news and ideas.

Trade is probably the channel that gets most attention from the public. Donald Trump’s populist campaigning against globalisation has focus on the belief that America’s greater openness to trade – particularly with developing countries – has caused it to lose many jobs, particularly in manufacturing, as cheaper imports caused many domestic producers to lose sales, or as factories have been moved offshore to countries where wages are lower, without America receiving anything much in return. These sentiments would be shared by many voters for One Nation.

Surprisingly, financial globalisation didn’t get as much blame as it could have for the global financial crisis and the Great Recession it precipitated. But it’s easier for Australians to remember that the global crisis of 2008 was preceded by the Asian financial crisis of 1997-98, indicating that our highly integrated global financial markets are prone to crises – crises which invariably spill over from the “financial economy” of borrowing and lending, saving and investing, to the “real economy” of producing and consuming goods and services. The push by the G20 to strengthen the capital and liquidity requirement imposed on the world’s banks, though the Basel agreements, is intended to make financial markets more stable.

Most countries have not liberalised the flow of labour into their economy in the way they have the other factors of production. Although increasing numbers of people are fleeing their country to escape war, famine and persecution, many choose the country they’d like to arrive at on economic grounds. Many voters object to the inflow of immigrants, whether they be boat people arriving in Australia, Mexicans crossing the border to the US, or Poles taking advantage of the European Union’s single market to look for jobs in Britain. Immigration seems to have been a major motive for some Brits voting in favour of Brexit.

Income distribution and the gains from trade

One of economists’ core beliefs is that there are mutual gains from trade. Provided the exchange of goods is voluntary, each side participates only because it sees some advantage for itself. This is undoubtedly true, but in the era of renewed globalisation we’ve been reminded that, though the gains may be mutual, they are not necessarily equal. Some countries do better than others.

Similarly, the benefits to a particular country from its trade aren’t necessarily equally distributed between the people within that country. When, for example, a country imports more of its manufactured goods because they are cheaper than its locally made goods, all the consumers who buy those goods are better off (including all the working people), but many workers in the domestic manufacturing industry may lose their jobs.

Another factor that has been working in the same direction is digitisation and other technological change which, in its effect on employers’ demand for labour, seems to be “skill-biased” – that is, it tends to increase the value of highly skilled labour, while reducing the value of less-skilled labour. It seems likely that, between them, trade and technological advance have worked to shift the distribution of income in America, Britain and, to a lesser extent, Australia, in favour of high-income families and against many middle and lower-income families.

The unwelcome surprise many politicians and economists have received from the high protest votes for Brexit, Trump and One Nation is causing them to wonder if too little has been done to assist the workers and regions adversely affected to retrain and relocate, and too little to ensure the winners from structural change bear most of the cost of this assistance.

Shares of the World Economy, 2018

GWP Exports Population

China          19   11     19

United States   15   10         4

Euro area (19 countries)   11   26         5

India     8     2       18

Japan     4     4         2

Advanced economies (39) 41   63       14

Developing economies (155) 59   37       86

            100 100     100

Source: IMF WEO statistical appendix; GWP based on purchasing power parity   

Read more >>