The Twin Excesses

In their effort to explain the global crisis analysts have identified lax regulation and other attributes of the financial system as the principal culprits. To grasp fully the reason it also needs to be recognized that this is the first crisis of the modern era of globalization. If the proximate cause is the "laissez faire" to "laissez financer" progression in free-market idolatry, leading to bubbles in asset prices and the subsequent crash, then the facilitating condition was yet another quasi-bubble – a bubble in globalization. It may be easier to appreciate the virulence and speed with which the crisis has spread if we recognize that in addition to over-financialization domestically, there was perhaps over-globalization internationally.

While over-globalization was evident in ever-faster trade and capital flows and increasing off-shoring of production, over-financialization could be seen in rise in the size of financial assets relative to the real economy as indicated by gross domestic product. Globally, the holdings of financial assets, comprising equities, government and private bonds and bank deposits ballooned way out of proportion to global GDP, the primary underlying measure of real economic activity (see Figure 1). Similarly, the gross market value of outstanding derivative contracts more than doubled between mid-2006 and mid-2008. The share of financial services in GDP has increased dramatically in the US and UK in recent years; in the latter it has doubled in the last decade alone. In many countries, the financial sector grew to a size disproportionate to its primary raison d'etre - to efficiently bring savers and borrowers together, allocate savings to viable investments, and manage diversification of risk. Liquid and deep financial markets are necessary; indeed, they are the lifeblood of economic activity, but to extend the analogy, not if they cause high blood pressure to the economy!

Globalization too has played its role. A large part of the new trade volumes generated were a result of diversion from potential consumption by domestic consumers to consumption by consumers half-way across the world. There is an ongoing debate in China, for example, whether the economic wisdom of having nearly a 40 percent share of exports in GDP has served the developmental goals of the country well. At least some of the blame for income inequality, lopsided development and consumption stagnation in the country can be laid at the feet of the overgrown external sector.

Global imbalances, on which reams have been written, provided the financing for the insatiable appetite of US and other consumers, met by the unbounded capacity of China’s manufacturing machine. Footloose capital ran hither and thither for better returns and ended up in high risk investments. The US-China globalization axis may have been critical but by no means was it the only game in town. Reckless lending by western banks to East European clients drove much of the importing frenzy in those countries. It was finance that drove and propelled international trade, in addition to that generated by underlying patterns of global specialization and competitiveness.

Together with the financial sector, globalization, as we know it –global trade in goods and services, capital flows and off-shoring of production – seems destined to decline in the short term. The total market value of financial assets held worldwide has declined by about a third, or more than $50 trillion, in 2008 according to a report by the Asian Development Bank. Container traffic in the world’s busiest ports is down by more than 20 percent. While trade volumes show greater volatility than GDP, the figures for the former show a near precipitous decline relative to the former. The IMF expects global GDP to decrease by 1.3 percent in 2009, while economists from the World Trade Organization forecast a 9 percent decline for global trade in the same year, both the largest drops on record since World War II. Export volumes are expected to decrease in every major region of the world. Indeed, double-digit declines in real national variables are so rare that declines in export volumes of over 30 percent, such as in the case of Japan, make one wonder about the "bubble-like" nature of the underlying demand. On the other hand, while Euro area GDP and US GDP are both expected to contract in 2009, emerging economies are the one bright spot with a GDP growth forecast of 1.6 percent.

In addition to trade, global financial flows and cross-border investments are also expected to be adversely affected. The most dynamic economic region of the world, Emerging Asia, is expected to attract 40 percent less net private capital flows (which include portfolio and direct investments) in 2009. It is as if both ships and funds in search of a safe harbor are docked at home ports.

The prospect of offshoring, that recent offspring of globalization, presents a mixed picture. While any downturn can only serve to further intensify the ever-present cost-cutting impulse on the part of management, the fundamental nature of downsizing and restructuring underway in the US in key sectors, and the sharp cutbacks in many parent operations in the financial services sector suggest that even the seemingly unstoppable phenomenon of offshoring may slow down. Already, there have been some cutbacks in the number of employees of offshore call centers.

Increasing interventions by national governments in the economic management of individual nation-states also tend to slow down the globalization process. National stimulus packages have a domestic stance and are inward-oriented, regardless of whether there is an explicit "buy domestic" provision, since greater reliance on government spending inevitably leads to less "leakage" internationally. The mounting job losses, complexity of the financial crisis, increasing range of conflicting interests, issues of inequality and fairness, and last, but not least, compulsions of electoral politics in an increasingly democratic world will all lead to greater state intervention, curbing the power of the market.

Far too rapid and distorted growth in global economic linkages and the financial services sector, as well as their mutual feeding off each other, have brought into sharper focus contradictions facing the future evolution of the global economy, the resolution of which is bound to affect globalization. While the future shape of regulatory reform is being vigorously debated, it is not clear how continued globalization will be affected in the medium-term by the crisis.

All of this leads us to the following question: can we eat our cake, have it too, and trade it in on the global markets? Dani Rodrik has long pointed out the "inescapable trilemma of the world economy," that "democracy, national sovereignty and global economic integration are mutually incompatible." The present crisis shows that it is actually a quadrilemma. The international policy establishment must manage and reconcile the simultaneously conflicting pulls and pushes of, first, universal free market economic principles, operating; secondly, in individual nation-states, the primary arena of economic policy, which are largely shaped by, thirdly, a democratic polity that is in turn apprehensive and insecure about, fourthly, increasing free trade and international economic integration. It is difficult to see how the tenuous co-habitation of these four – globalization, free-market principles, democracy, and national policy independence – can survive in the present circumstances. Something may have to give way, if just a little...

Ashok Bardhan is an economist at UC Berkeley. Rights: © Copyright 2009 Yale Center for the Study of Globalization.YaleGlobal Online