By Michael Pettis
About ten years ago I published an article in Foreign Policy that I just recently re-read. In the article I extended one of the arguments I made in my book, The Volatility Machine, that the globalization process is driven primarily by monetary expansion and the consequent increase in risk appetite. What was new in this piece, because I hadn’t realized it when I wrote my book, is that every period of globalization coincided with a stage of the industrial revolution in which accompanying the expansion in international trade and capital flows is a major technological boom, driven also by monetary expansion.
After re-reading the article I thought it might be useful to republish it on my blog with a couple of comments while waiting for the next entry (which should come out this week). I think the point it makes about the process in which globalization is reversed is still worth considering.
Will Globalization Go Bankrupt?
“Only the young generation which has had a college education is capable of comprehending the exigencies of the times,” wrote Alphonse, a third-generation Rothschild, in a letter to a family member in 1865. At the time the world was in the midst of a technological boom that seemed to be changing the globe beyond recognition, and certainly beyond the ability of his elders to understand. As part of that boom, capital flowed into remote corners of the earth, dragging isolated societies into modernity. Progress seemed unstoppable.
Eight years later, however, markets around the world collapsed. Suddenly, investors turned away from foreign adventures and new technologies. In the depression that ensued, many of the changes eagerly embraced by the educated young — free markets, deregulated banks, immigration — seemed too painful to continue. The process of globalization, it seems, was neither inevitable nor irreversible.
What today we call economic globalization — a combination of rapid technological progress, large-scale capital flows, and burgeoning international trade — has happened many times before in the last 200 years. During each of these periods (including our own), engineers and entrepreneurs became folk heroes and made vast fortunes while transforming the world around them. They exploited scientific advances, applied a succession of innovations to older discoveries, and spread the commercial application of these technologies throughout the developed world. Communications and transportation were usually among the most affected areas, with each technological surge causing the globe to “shrink” further.
But in spite of the enthusiasm for science that accompanied each wave of globalization, as a historical rule it was primarily commerce and finance that drove globalization, not science or technology, and certainly not politics or culture. It is no accident that each of the major periods of technological progress coincided with an era of financial market expansion and vast growth in international commerce. Specifically, a sudden expansion of financial liquidity in the world’s leading banking centers — whether an increase in British gold reserves in the 1820s or the massive transformation in the 1980s of illiquid mortgage loans into very liquid mortgage securities, or some other structural change in the financial markets — has been the catalyst behind every period of globalization.
If liquidity expansions historically have pushed global integration forward, subsequent liquidity contractions have brought globalization to an unexpected halt. Easy money had allowed investors to earn fortunes for their willingness to take risks, and the wealth generated by rising asset values and new investments made the liberal ideology behind the rapid market expansion seem unassailable. When conditions changed, however, the outflow of money from the financial centers was reversed. Investors rushed to pull their money out of risky ventures and into safer assets. Banks tightened up their lending requirements and refused to make new loans. Asset values collapsed. The costs of globalization, in the form of social disruption, rising income inequality, and domination by foreign elites, became unacceptable. The political and intellectual underpinnings of globalization, which had once seemed so secure, were exposed as fragile, and the popular counterattack against the logic of globalization grew irresistible.
The big bang
The process through which monetary expansions lead to economic globalization has remained consistent over the last two centuries. Typically, every few decades, a large shift in income, money supply, saving patterns, or the structure of financial markets results in a major liquidity expansion in the rich-country financial centers. The initial expansion can take a variety of forms. In England, for example, the development of joint-stock banking (limited liability corporations that issued currency) in the 1820s and 1830s — and later during the 1860s and 1870s — produced a rapid expansion of money, deposits, and bank credit, which quickly spilled over into speculative investing and international lending. Other monetary expansions were sparked by large increases in U.S. gold reserves in the early 1920s, or by major capital recyclings, such as the massive French indemnity payment after the Franco-Prussian War of 1870, the petrodollar recycling of the 1970s, or the recycling of Japan’s huge trade surplus in the 1980s and 1990s. Monetary expansions also can result from the conversion of assets into more liquid instruments, such as with the explosion in U.S. speculative real-estate lending in the 1830s or the creation of the mortgage securities market in the 1980s.
The expansion initially causes local stock markets to boom and real interest rates to drop. Investors, hungry for high yields, pour money into new, nontraditional investments, including ventures aimed at exploiting emerging technologies. Financing becomes available for risky new projects such as railways, telegraph cables, textile looms, fiber optics, or personal computers, and the strong business climate that usually accompanies the liquidity expansion quickly makes these investments profitable. In turn, these new technologies enhance productivity and slash transportation costs, thus speeding up economic growth and boosting business profits. The cycle is self-reinforcing: Success breeds success, and soon the impact of rapidly expanding transportation and communication technology begins to cause a noticeable impact on social behavior, which adapts to these new technologies.
But it is not just new technology ventures that attract risk capital. Financing also begins flowing to the “peripheral” economies around the world, which, because of their small size, are quick to respond. These countries then begin to experience currency strength and real economic growth, which only reinforce the initial investment decision. As more money flows in, local markets begin to grow. As a consequence of the sudden growth in both asset values and gross domestic product, political leaders in developing countries often move to reform government policies in these countries — whether reform consists of expelling a backward Spanish monarch in the 1820s, expanding railroad transportation across the Andes in the 1860s, transforming the professionalism of the Mexican bureaucracy in the 1890s, deregulating markets in the 1920s, or privatizing bloated state-owned firms in the 1990s. By providing the government with the resources needed to overcome the resistance of local elites, capital inflows enable economic-policy reforms.
This relationship between capital and reform is frequently misunderstood: Capital inflows do not simply respond to successful economic reforms, as is commonly thought; rather, they create the conditions for reforms to take place. They permit easy financing of fiscal deficits, provide industrialists who might oppose free trade with low-cost capital, build new infrastructure, and generate so much asset-based wealth as to mollify most members of the economic and political elite who might ordinarily oppose the reforms.
Policymakers tend to design such reforms to appeal to foreign investors, since policies that encourage foreign investment seem to be quickly and richly rewarded during periods of liquidity. In reality, however, capital is just as likely to flow into countries that have failed to introduce reforms. It is not a coincidence that the most famous “money doctors” — Western-trained thinkers like French economist Jean-Gustave Courcelle-Seneuil in the 1860s, financial historian Charles Conant in the 1890s, and Princeton University economist Edwin Kemmerer in the 1920s, under whose influence many developing countries undertook major liberal reforms — all exerted their maximum influence during these periods. During the 1990s, their modern counterparts advised Argentina on its currency board, brought “shock therapy” to Russia, convinced China of the benefits of membership in the World Trade Organization, and everywhere spread the ideology of free trade.
The pattern is clear: Globalization is primarily a monetary phenomenon in which expanding liquidity induces investors to take more risks. This greater risk appetite translates into the financing of new technologies and investment in less developed markets. The combination of the two causes a “shrinking” of the globe as communications and transportation technologies improve and investment capital flows to every part of the globe. Foreign trade, made easier by the technological advances, expands to accommodate these flows. Globalization takes place, in other words, largely because investors are suddenly eager to embrace risk.
The big crunch
As is often forgotten during credit and investment booms, however, monetary conditions contract as well as expand. In fact, the contraction is usually the inevitable outcome of the very conditions that prompted the expansion. In times of growth, financial institutions often overextend themselves, creating distortions in financial markets and leaving themselves vulnerable to external shocks that can force a sudden retrenchment in credit and investment. In a period of rising asset prices, for example, it is often easy for even weak borrowers to obtain collateral-based loans, which of course increases the risk to the banking system of a fall in the value of the collateral. For example, property loans in the 1980s dominated and ultimately brought down the Japanese banking system. As was evident in Japan, if the financial structure has become sufficiently fragile, a retrenchment can lead to a collapse that quickly spreads throughout the economy.
Since globalization is mainly a monetary phenomenon, and since monetary conditions eventually must contract, then the process of globalization can stop and even reverse itself. Historically, such reversals have proved extraordinarily disruptive. In each of the globalization periods before the 1990s, monetary contractions usually occurred when bankers and financial authorities began to pull back from market excesses. If liquidity contracts — in the context of a perilously overextended financial system — the likelihood of bank defaults and stock market instability is high. In 1837, for example, the U.S. and British banking systems, overdependent on real estate and commodity loans, collapsed in a series of crashes that left Europe’s financial sector in tatters and the United States in the midst of bank failures and state government defaults.
The same process occurred a few decades later. Alphonse Rothschild’s globalizing cycle of the 1860s ended with the stock market crashes that began in Vienna in May 1873 and spread around the world during the next four months, leading, among other things, to the closing of the New York Stock Exchange (NYSE) that September amid the near-collapse of American railway securities. Conditions were so bad that the rest of the decade after 1873 was popularly referred to in the United States as the Great Depression.
Nearly 60 years later, that name was reassigned to a similar episode — the one that ended the Roaring Twenties and began with the near-breakdown of the U.S. banking system in 1930–31. The expansion of the 1960s was somewhat different in that it began to unravel during the early and mid-1970s when, thanks partly to the OPEC oil price hikes and subsequent petrodollar recycling, a second liquidity boom occurred, and lending to sovereign borrowers in the developing world continued through the end of the decade.
However, the cycle finally broke down altogether when rising interest rates and contracting money engineered by then Federal Reserve Chairman Paul Volcker helped precipitate the Third World debt crisis of the 1980s. Indeed, with the exception of the globalization period of the early 1900s, which ended with the advent of World War I, each of these eras of international integration concluded with sharp monetary contractions that led to a banking system collapse or retrenchment, declining asset values, and a sharp reduction in both investor risk appetite and international lending.
Following most such market crashes, the public comes to see prevalent financial market practices as more sinister, and criticism of the excesses of bankers becomes a popular sport among politicians and the press in the advanced economies. Once capital stops flowing into the less developed, capital-hungry countries, the domestic consensus in favor of economic reform and international integration begins to disintegrate. When capital inflows no longer suffice to cover the short-term costs to the local elites and middle classes of increased international integration — including psychic costs such as feelings of wounded national pride — support for globalization quickly wanes. Populist movements, never completely dormant, become reinvigorated. Countries turn inward. Arguments in favor of protectionism suddenly start to sound appealing. Investment flows quickly become capital flight.
This pattern emerged in the aftermath of the 1830s crash, when confidence in free markets nose-dived and the subsequent populist and nationalist backlash endured until the failure of the much-dreaded European liberal uprisings of 1848, which saw the earliest stirrings of communism and the publication of the Communist Manifesto. Later, in the 1870s, the economic depression that followed the mass bank closings in Europe, the United States, and Latin America was accompanied by an upsurge of political radicalism and populist outrage, along with bouts of protectionism throughout Europe and the United States by the end of the decade. Similarly, the Great Depression of the 1930s also fostered political instability and a popular revulsion toward the excesses of financial capitalism, culminating in burgeoning left-wing movements, the passage of anti-bank legislation, and even the jailing of the president of the NYSE.
Profits of doom
Will these patterns manifest themselves again? Indeed, a new global monetary contraction already may be under way. In each of the previous contractions, stock markets fell, led by the collapse of the once-high-flying technology sector; lending to emerging markets dried up, bringing with it a series of sovereign defaults; and investors clamored for safety and security.
Consider the crash of 1873, a typical case: Then, the equivalent of today’s high-tech sector was the market for railway stocks and bonds, and the previous decade had seen a rush of new stock and bond offerings that reached near-manic proportions in the early 1870s. The period also saw rapid growth of lending to Latin America, southern and eastern Europe, and the Middle East. Wall Street veterans had expressed nervousness about market excesses for years leading up to the crash, but the exuberance of investors who believed in the infinite promise of the railroads, at home and abroad, coupled with the rising prominence of bull-market speculators like Jay Gould and Diamond Jim Brady, swept them aside. When the market collapsed in 1873, railway securities were the worst hit, with many companies going bankrupt and closing their doors. Major borrowers from the developing world were unable to find new financing, and a series of defaults spread from the Middle East to Latin America in a matter of months. In the United States, the Congress and press became furious with the actions of stock market speculators and pursued financial scandals all the way to President Ulysses S. Grant’s cabinet. Even Grant’s brother-in-law was accused of being in cahoots with a notorious group that attempted a brutal gold squeeze.
Today, we see many of the same things. The technology sector is in shambles, and popular sentiment has turned strongly against many of the Wall Street heroes who profited most from the boom. Lending to emerging markets has all but dried up. As of this writing, the most sophisticated analysts predict that a debt default in Argentina is almost certain — and would unleash a series of other sovereign defaults in Latin America and around the world. The yield differences between risky assets and the safest and most liquid assets are at historical highs. In short, investors seem far more reluctant to take on risk than they were just a few years ago.
This lower risk tolerance does not bode well for poor nations. Historically, many developing countries only seem to experience economic growth during periods of heavy capital inflow, which in turn tend to last only as long as the liquidity-inspired asset booms in rich-country financial markets. Will the international consensus that supports globalization last when capital stops flowing? The outlook is not very positive. While there is still broad support in many circles for free trade, economic liberalization, technological advances, and free capital flows — even when the social and psychic costs are acknowledged — we already are witnessing a strong political reaction against globalization. This backlash is evident in the return of populist movements in Latin America; street clashes in Seattle, Prague, and Quebec; and the growing disenchantment in some quarters with the disruptions and uncertainties that follow in the wake of globalization.
The leaders now gathered in opposition to globalization — from President Hugo Chávez in Venezuela to Malaysian Prime Minister Mahathir bin Mohamad to anti-trade activist Lori Wallach in the United States — should not be dismissed too easily, no matter how dubious or fragile some of their arguments may seem. The logic of their arguments may not win the day, but rather a global monetary contraction may reverse the political consensus that was necessary to support the broad and sometimes disruptive social changes that accompany globalization. When that occurs, policy debates will be influenced by the less emotional and more thoughtful attacks on globalization by the likes of Robert Wade, a professor of political economy at the London School of Economics, who argues forcefully that globalization has actually resulted in greater global income inequality and worse conditions for the poor.
If a global liquidity contraction is under way, antiglobalization arguments will resonate more strongly as many of the warnings about the greed of Wall Street and the dangers of liberal reform will seem to come true. Supposedly irreversible trends will suddenly reverse themselves. Further attempts to deepen economic reform, spread free trade, and increase capital and labor mobility may face political opposition that will be very difficult to overcome, particularly since bankers, the most committed supporters of globalization, may lose much of their prestige and become the target of populist attacks following a serious stock market decline. Because bankers are so identified with globalization, any criticism of Wall Street will also implicitly be a criticism of globalizing markets.
Financiers, after all, were not the popular heroes in the 1930s that they were during the 1920s, and current events seem to mirror past backlashes. Already the U.S. Securities and Exchange Commission, which was created during the Great Depression of the 1930s, is investigating the role of bankers and analysts in misleading the public on the market excesses of the 1990s. In June 2001, the industry’s lobby group, the Securities Industry Association, proposed a voluntary code, euphemized as “a compilation of best practices… to ensure the ongoing integrity of securities research and analysis,” largely to head off an expansion of external regulation. Increasingly, experts bewail the conflicts of interest inherent among the mega-banks that dominate U.S. and global finance.
Globalization itself always will wax and wane with global liquidity. For those committed to further international integration within a liberal economic framework, the successes of the recent past should not breed complacency since the conditions will change and the mandate for liberal expansion will wither. For those who seek to reverse the socioeconomic changes that globalization has wrought, the future may bring far more progress than they hoped. If global liquidity contracts and if markets around the world pull back, our imaginations will once again turn to the increasingly visible costs of globalization and away from the potential for all peoples to prosper. The reaction against globalization will suddenly seem unstoppable.
In re-reading the article it is clear that I was a little premature. I expected that we were just two or three years away from the big global contraction, when in fact it was nearly six years away. The “Greenspan put” was once again exercised and the market bailed out, but as Hyman Minsky would probably have pointed out had he been alive, this would only ensure that the crisis, when it eventually came, would be worse. By preventing the market from adjusting to theimbalances generated in the 1990s, policymakers effectively forced the financial system to adjust by taking on even more risk, just as Minsky described.
As the students in my central bank seminar at Peking University discussed in class last week, Minsky’s analysis has important implications for China. It suggests that every time Beijing takes steps to prevent financial volatility, they may simply be forcing the banking system to ratchet up the risk. Eventually it becomes very hard to prevent the system from clearing anyway, but it does so with a much greater amount of risk embedded in the system.
At any rate the key point is that changes in risk appetite, which are often driven by changes in underlying liquidity, have a number of important balance sheet consequences. During the period of rising liquidity it may be easy to ignore those consequences, especially since rising asset prices and cheap liquidity obscure the risks, but when the contraction comes, as it always must, we are often surprised by the range of conditions that change and how dramatic that changes can be.