Global Economic Integration: Opportunities and Challenges— a Summary of the Bank’S 2000 Symposium

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Global Economic Integration: Opportunities and Challenges— A Summary of the Bank’s 2000 Symposium

By George A. Kahn

he increasingly integrated global econ- ECONOMIC INTEGRATION, omy presents policymakers with both FINANCIAL MARKETS, AND TRADE Topportunities and challenges. Global economic integration is widely thought to improve The first day of the symposium covered a vari- the allocation of resources, promote technology ety of issues from various perspectives, including transfer, and enhance living standards. But, at those of Federal Reserve Chairman Alan the same time, economic integration has fre- Greenspan, two financial market regulators, and quently been blamed for growing trade imbal- several public-sector and academic economists. ances, increased financial market volatility, and The session started with a discussion of the fac- less effective domestic macroeconomic policies. tors driving global economic integration, then turned to financial market issues. Academic To better understand how policymakers can economists gave their views on how economic maximize the benefits from globalization while integration has affected financial market stabil- recognizing the challenges, the Federal Reserve ity, and a panel of regulatory specialists dis- Bank of Kansas City sponsored a symposium cussed possible policy responses. The day entitled, “Global Economic Integration: Oppor- concluded with an overview of trade issues from tunities and Challenges,” held at Jackson Hole, the perspective of the Director-General of the Wyoming, on August 24-26, 2000. The sympo- World Trade Organization (WTO). sium brought together a distinguished group of central bankers, academics, and financial market Driving forces experts. Participants at the symposium agreed that globalization has produced net economic In his opening comments, Chairman benefits for national economies and outlined a Greenspan defined globalization as “the increas- variety of approaches for addressing the associ- ing interaction of national economic systems.” ated challenges. He linked this trend to technological progress and to government policies that have promoted deregulation and privatization in markets around the world. In particular, technological George A. Kahn is a vice president and economist at the Federal Reserve Bank of Kansas City. Edee Sweeney, a research associate improvements have lowered transactions and at the bank, helped prepare the article. This article is on the information costs, promoting the efficient oper- bank’s web site at www.kc.frb.org. ation of market-based economic systems. The Kahn.qxd 2/12/01 10:05 AM Page 6

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resulting expansion of markets has been associ- port, the economic prosperity that global inte- ated with increased competition and reduced gration has fostered will likely act as an effective tariffs and trade barriers. counterweight. Moreover, despite occasional financial crises, most nations have shown little Looking ahead, Greenspan questioned desire to withdraw from the increasingly inte- whether the trend toward global economic integrated world economy. In fact, nations that have gration and free markets would continue as rap- lagged behind in the process of integration gen- idly as in the past. The central tenants of free erally want to catch up. markets—competition and the Schumpeterian process of “creative destruction”—raise concerns Commenting on Mussa’s paper, Douglas in some quarters about the unequal distribution Irwin agreed that technology, preferences, and of wealth and the “civility of society.” Accord- policy have shaped U.S. trade in the 1990s. ingly, if the recent period of economic growth Irwin made three key points, focusing on trade. were to subside, support for free markets and First, public policy has driven trade flows in the trade liberalization could fade. 1990s both on its own terms and in interaction with technology. Second, public support for Following Greenspan’s comments, Michael integration is more likely when trade is driven Mussa examined various factors that have con- by technology rather than public policy. And tributed to global economic integration and are third, opposition to policies promoting trade has likely to contribute in the future. According to largely come from special interest groups whose Mussa, factors driving integration fall into three influence may be waning. categories—technology, preferences, and public policy. These factors have acted individually and Irwin shared Mussa’s view that the process of interactively in driving integration. integration would continue. While unskilled workers, acting in their own interest, may con- Improvements in technology have bolstered tinue to resist freer trade, Irwin did not expect a integration by lowering the cost of transporting resurgence of isolationist policies. The key to goods and people from one place to another and enacting trade-expanding policies, he said, is an by reducing the cost of communicating ideas. educated and highly skilled work force. Social and individual preferences for the benefits of globalization—including an increasing vari- Effects of increased economic integration ety of goods and services—have also con- on financial stability tributed to integration. In contrast, public policy has at times promoted integration while After the discussion of factors driving integra- at other times has acted as a barrier to globalization, Paul Krugman examined whether financial tion. Given these driving forces, Mussa exam- crises might be an inevitable consequence of ined how human migration and increasing trade globalization. His paper contrasted the view and financial flows have defined the process of prevalent in the early 1980s that economic inte- global integration. gration reduced the risk of financial crisis with the view today that financial crises result from In assessing future prospects, Mussa was opti- self-fulfilling panics that can occasionally mistic. He suggested that the process of integra- develop in an integrated world economy. The tion would continue because of continued paper then assessed various proposals to reduce technical innovation and favorable public poli- the risk of crisis and discussed how increasing cies. While there is always a risk that those trade affects the relative merits of alternative opposed to globalization will gain political sup- policy solutions. Kahn.qxd 2/12/01 10:05 AM Page 7

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Krugman concluded that the process of glob- How should financial market alization did increase the risk of financial crisis. regulators respond? Moreover, policies that address this increased risk involve tradeoffs. Policies that reduce the Following the discussion of how economic risk of financial crisis through restrictions on integration affects financial stability, a panel of capital flows do so at a cost that increases with experts discussed how financial market regula- trade flows. And, policies that protect against tors should respond to the associated challenges. financial crisis through dollarization or “euroiza- tion” cause all of the adjustment to real shocks Andrew Crockett identified the objectives of to occur through inflation or deflation. financial regulation as efficiency, stability, and competitive equity. Efficiency means the price of Despite these policy tradeoffs, Krugman sug- risk reflects its cost. Stability means striking a gested that, in the long run, increasing trade proper balance between the inevitable and posi- could eventually lead to a reduced risk of finan- tive adaptations and changes that occur in a cial crisis. He pointed to two reasons. First, as market system while avoiding the kinds of trade increases relative to national output, so instability that carry unacceptable costs. Com- does the likelihood that a depreciation of the petitive equity means a state of “genuine com- currency will have net expansionary effects. Sec- petition among institutions,” under which the ond, globalization will eventually reduce the benefits of competition are maximized. risk of financial crisis because it is associated with increased direct investment, which is inher- To ensure efficiency, stability, and competitive ently less risky than portfolio investment. equity, Crockett said regulators should not attempt to resist market forces, but rather Commenting on Krugman’s paper, Charles should address market failures. Specifically, he Goodhart argued that modern financial crises suggested improving risk management practices were not so much the result of global integration at the firm level, improving supervisory over- but of financial market deregulation and liberal- sight techniques, and increasing market disci- ization. Relatively calm financial markets from pline through greater transparency and robust 1945 to 1973 were associated with a stable sys- accounting practices. Crockett also identified a tem of pegged exchange rates, wide-ranging number of practical issues facing policymakers controls over capital flows, and strict limitations in a world of increasing economic integration. on banking activities. The loosening of these reg- Among these issues were the role of regulatory ulations after 1973 produced net economic ben- competition, the coverage of standards across a efits, but also paved the way for financial crises. variety of financial institutions, and the role of central banks. To limit financial crises in the future, Good- hart advocated the development of domestic Howard Davies argued that there was no “sin- bond and securitized mortgage markets in gle silver bullet solution” to addressing the emerging economies to reduce the need for shortcomings of the current international regu- bank and foreign currency borrowing. In addi- latory system. Indeed, he suggested a ten-point tion, he argued for broadening our concept of plan to improve the system. The key points in bank and financial market regulation to include the plan were: developing globally agreed-upon mechanisms for limiting volatile short-term cap- standards of disclosure; improving disclosure of ital flows. leverage in the financial system; implementing standards and codes; giving greater consideration to the practical aspects of supervising com- Kahn.qxd 2/12/01 10:05 AM Page 8

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plex global institutions; naming a “lead supervi- World trade policy sor” for each group of internationally active institutions; increasing “mutual reliance” among In a luncheon address, Mike Moore focused on supervisors; simplifying and rationalizing the failure of the WTO to launch a new round of national regulatory structures; filling a number trade talks in Seattle. He suggested the dynam- of existing gaps in the regulatory structure; ics of the process had changed since the Uruguay improving international enforcement; and edu- Round, making it unlikely in four key areasthat cating the public on the implications of global- a new round could be successfully launched in ization for saving and investing. the near future. First, controversial issues such as labor and the environment are now part of the Randall Kroszner emphasized the role of pri- negotiations. Second, more parties are involved vate-sector “regulation” as part of a complete in the negotiations. Third, popular support for regulatory system. He put forth the view that free trade has declined. And fourth, the need for the private sector would continue to “demand” leadership and flexibility has increased. regulation even as the world economy became more integrated. But this demand would be Given these challenges, Moore concluded that met, not just by public-sector regulators, but launching a new round would be difficult but also through the private sector itself. In fact, as not impossible. What is required is “sustained financial market innovation and globalization pressure on governments” to generate “the make traditional public regulation less effective, political will needed to adopt more flexible posi- various private sources are providing a greater tions in sensitive areas.” He drew some opti- share of the supply of regulation. And, competi- mism from the negotiations on financial services tion among the various public and private sup- that are currently under way in Geneva. These pliers of regulation helps increase the benefits negotiations are proceeding without contro- and reduce the costs of regulation. versy. They also are demonstrating the speed with which economic integration has advanced Kroszner identified four forms of private regu- in the last ten years. lation—“members only” organizations, volun- tary standard-setting bodies, innovative firm MACROECONOMIC STABILITY structures, and third-party monitors—that AND MONETARY POLICY work together and in competition with traditional public-sector regulators. After showing The second day of the symposium focused on how these private sources of regulation operate macroeconomic issues. It started with a discussion in the derivatives and banking markets, of how economic integration affects macroeco- Kroszner discussed how public regulators have nomic stability, then turned to a consideration of responded to the globalization of financial mar- how monetary policymakers should respond to kets. He concluded that the financial market the challenges of global economic integration. challenges of globalization could be met The day concluded with an overview panel that through a “deeper analysis of the robustness of addressed what the future might hold. the private sources of regulation and a further understanding of how political economy forces Effects of increased economic integration shape the implementation and enforcement of on macroeconomic stability public regulation.” Maurice Obstfeld and Kenneth Rogoff argued that globalization has not yet reached the point where large current account deficits can be sus- Kahn.qxd 2/12/01 10:05 AM Page 9

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tained in the U.S. economy without serious adjustment and described how the economies of implications for the world economy. As a result, other countries and regions could affect, and be the medium-term macroeconomic effects of a affected by, the adjustment. rapid turnaround in the U.S. current account deficit could be “quite dramatic.” The adjust- Drawing on research from the OECD, Visco ment could involve a very large depreciation of offered an alternative estimate of the effect of an the dollar and, at the same time, a sharp drop in adjustment in the U.S. current account on the the demand for nontradable goods. foreign exchange value of the dollar. In arriving at his estimate, Visco attributed part of the cur- Obstfeld and Rogoff based their conclusions rent account deficit to cyclical factors, lowering 1 on the segmentation—or lack of integration—of the structural component to around 3 ⁄2 percent international markets relative to domestic mar- of GDP. Visco also argued that, due to a variety kets. The segmentation of international markets of factors, a small current account deficit of 1 is evident from a variety of measures including around ⁄2 percent of GDP was sustainable in the international price deviations and home bias in United States. Using Obstfeld and Rogoff’s the demand for both equity and goods. Such model and assuming no short-run rigidities, impediments to trade have caused the share of Visco estimated that a reduction in the structural 1 1 U.S. goods traded internationally to remain rela- deficit from 3 ⁄2 percent to ⁄2 percent of GDP tively small. In addition, segmentation implies would require an 8.5 percent depreciation of the that large movements in prices and exchange dollar—somewhat less than the Obstfeld-Rogoff rates can result from a current account adjust- estimate. But in Visco’s view estimates like these ment of 4 to 5 percent of GDP, which is roughly may be misleading because the adjustment role the size of today’s current account deficit in the of the exchange rate will depend on the type of U.S. economy. shock that triggers the current account adjustment and on the monetary policy response. Obstfeld and Rogoff estimated that, if the U.S. current account were to move rapidly into How should monetary policymakers respond? balance, the real exchange value of the dollar could fall by as much as 40 percent or more, Following the discussion of how economic depending on the monetary policy response of integration affects macroeconomic stability, a the Federal Reserve. In contrast, they estimated panel of central bankers discussed how mone- that a more gradual elimination of the current tary policy should respond to the macroeco- account deficit over a period of three to five nomic challenges. years would lead to an adjustment in the real exchange rate of about 12 percent. Donald Brash highlighted four issues related to global economic integration that affect cen- Commenting on Obstfeld and Rogoff’s paper, tral banks. First, increasing foreign trade is caus- Ignazio Visco agreed that international trade was ing greater integration of countries and regions segmented relative to domestic trade but argued and thereby increasing the appeal of regional that segmentation was gradually decreasing. He currency zones. Second, growing integration argued that the structural imbalance in the U.S. may have caused economies to become less current account might be smaller than Obstfeld inflation prone. Third, global financial institu- and Rogoff suggested and therefore might tions are developing at an accelerating rate, rais- require a smaller exchange rate adjustment. He ing issues about financial regulation and the examined how stabilization policies might influ- transmission of monetary policy. And fourth, ence the outcome of a large U.S. current account the increasing speed with which capital flows Kahn.qxd 2/12/01 10:05 AM Page 10

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around the world is making it more difficult for if markets are thin or dominated by a few central banks to achieve domestic objectives. agents. And, hedging exchange-rate risk may be costly if derivatives markets are not well devel- Focusing primarily on the last issue, Brash oped. While these costs are magnified in finan- described how monetary policy in New Zealand cially fragile economies, they can be lessened has responded to increased economic integration. through public and private-sector efforts to Two key challenges are the heightened response reduce financial vulnerability. of capital flows to changes in monetary policy and the disruptive effects of exchange-rate cycles Eugenio Domingo Solans discussed an to the macroeconomy. Among the key ingredi- approach to monetary policy called bounded dis- ents to successful management of external or cretion. He defined bounded discretion as “a for- internal shocks in an open economy are “clear, mula able to combine the judgment and transparent, and credible objectives” and “effec- flexibility of discretion with the discipline that is tive risk management.” The specific approach in achieved in the case of rule-based policy design New Zealand has been to adopt an explicit infla- through the automatic feedback between the tion target and to maintain floating exchange target and the instrument variables.” In such an rates and an open capital account. (Brash’s paper approach, reputation and institutional con- is reprinted in this issue of Economic Review.) straints would substitute for the automatic feedback component of a rule-based monetary Guillermo Ortiz discussed the benefits and policy. Solans argued that bounded discretion risks of globalization from the perspective of corresponded to the monetary policy framework developing countries. He argued that the most of the Eurosystem. attractive monetary regime for developing counties with open capital accounts is a flexible In responding to the challenges of globaliza- exchange-rate regime. After reviewing the tion, Solans said monetary policy should be advantages and disadvantages of such a regime, credible, realistic, and efficient. It should involve Ortiz identified policies that would maximize “a lack of activism, combined with smoothness, the benefits. He also discussed recent monetary judgment, flexibility, precommitment, time policy in Mexico in the context of a flexible consistency, transparency, and accountability. exchange-rate regime, increasing globalization, These requirements are better fulfilled by a dis- and high uncertainty. cretionary policy design supported by central bank independence, pre-established prioritized Ortiz reviewed several benefits and costs of objectives, a clearly specified encompassing floating exchange rates. On the positive side, strategy, enhanced communication, and demo- floating exchange rates limit the volatility of cratic control.” production and help prevent the buildup of external imbalances. They allow central banks Overview panel to pursue independent domestic monetary policies. They encourage capital to flow to longer The symposium concluded with overview com- term portfolio and direct investments, and they ments and perspectives on the future from Mar- eliminate any private-sector perception that the tin Feldstein, Stanley Fischer, and Jacob Frenkel. government will guarantee a particular value for the currency. On the downside, flexible Feldstein reviewed several benefits of eco- exchange rates lead to higher risk premiums and nomic integration that are often overlooked. therefore higher domestic interest rates. Flexible First, greater international capital flows allow exchange rates may contain limited information investors more opportunity to reduce risk Kahn.qxd 2/12/01 10:05 AM Page 11

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through diversification. Second, integration has tional labor and environmental standards could spread Anglo-American concepts of corporate be crafted in a reasonable and nonprotectionist governance, accounting practices, and legal tra- way. Volatility of international capital flows ditions. And third, integration has constrained could be reduced by the abandonment of “fixed- governments’ ability to enact bad fiscal and reg- but-adjustable” pegs in favor of either floating or ulatory policy. clearly fixed exchange rates. Advanced countries could reduce trade barriers in agriculture and Feldstein also described several benefits from textiles—areas of key concern to developing globalization caused by increases in foreign countries. International organizations could con- direct investment. In particular, foreign direct sider giving developing countries more decision- investment fosters technology transfer. It allows making influence. And, local and national the labor force in the host country to become cultures should be maintained and nurtured. better trained. It generates profits and tax rev- enues in the host country. And it allows the for- Fischer noted that, despite complaints, trade eign owners of capital to exploit economies of liberalization is continuing and most emerging scale. While the host country may tax profits market economies are maintaining open capital from foreign direct investment, the source coun- accounts. Looking ahead, he predicted that, if try benefits when the investment is financed by policymakers managed the process well, global- funds borrowed in the host country. ization would potentially benefit all countries and likely benefit most. Feldstein then gave his perspective on the causes of recent economic crises and policies to Frenkel discussed how economic integration prevent them in the future. The domestic causes, was shrinking distances and compressing time. which he said were exacerbated by the IMF’s Well functioning capital markets transform response, fell into three groups—exchange rate future expectations into the present, causing misalignments that created current account small policy changes to affect the market, not imbalances, a mismatch between short-term for- just through demand effects, but also through eign exchange liabilities and foreign exchange expectations of future policy. As a result, finan- reserves, and weak banking sectors under poor cial market volatility is amplified. The compres- supervision. The way to prevent crises in the sion of time also means that, with the benefit of future is to avoid exchange-rate misalignments technology and access to information, emerging and balance-sheet mismatches and to strengthen market economies can jump across stages of banking systems and regulations. development without going through the entire development process. In addition, because Fischer discussed how globalization affected expectations of the future affect the economy people’s daily lives and why globalization gener- today, policymakers have greater incentive to ates political controversy. He distinguished take the right actions. The benefits from doing between valid concerns for better globalization so accrue faster than in the past. and concerns that were purely self-serving. He then proposed measures to address the valid Frenkel also drew implications for exchange- concerns and pondered the future. rate regimes from the compression of time. In effect, the short run is determined by the long Fischer argued that globalization and the insti- run and there is no in between. Thus, if an tutions involved in making it work better should exchange-rate regime is nonsustainable in the be defended. But, at the same time, he sug- long run, it will not work in the short run. For gested several areas for improvement. Interna- example, a pegged-but-not-fixed exchange-rate Kahn.qxd 2/12/01 10:05 AM Page 12

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regime will eventually attempt to peg the Frenkel concluded by urging policymakers to exchange rate at the wrong level for too long. address problems now while the world economy The regime will collapse and credibility will be is relatively strong. “You should fix the roof on a lost. Because the regime is not credible in the sunny day rather than on a rainy day.” The only long run, it will not be credible in the short run. issue, he said, is political will. Therefore, countries will have to adopt either “very fixed” or “very flexed” exchange-rate regimes. By the same logic, Frenkel argued that exchange-market intervention is futile.