Chapter 12

Globalization and its challenge to Europe.

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12.1.Globalization and the law of one price.

The hype around globalization in early 21st century political and economic debates might convey an impression that we now are in an entirely new phase of economic development. This chapter will tell you that this presumption is wrong. A dose of elementary economic history is often helpful when popular media forget about the past.

Globalization is market integration on a world scale. Market integration means that domestic markets are increasingly dependent on international markets. Prices and hence factor rewards will reflect global demand and supply conditions rather than local. Globalization is the product of intensified trade, capital mobility and migration. In that process prices, interest ratesand sometimes wages tend to converge. The first wave of globalization started by the mid 19th century when barriers to trade, migration and capital mobility were abolished or weakened at the same time as the speed of information transmission increased. In most respects markets were as globalized around 1900 as they were in the beginning of the 21stcentury. In fact labour mobility across borders was less restricted before 1914 than it is now. However, there was a globalization backlash in the 20th century with two World Wars and the Great Depression. That policy reversal affected commodity, labour and capital markets to the extent that the late 19th century globalization level was not attained until the 1970s or 1980s when the second globalization period started.

Market integration operates through trade and arbitrage and the ultimate manifestation of a fully integrated market is the law of one price. The law of one price proposes that the price of identical goods that are traded is the same in all geographical locations.This is strictly true, of course, only if transport and transaction costs are zero, which they are not. Transport costs have fallen but remain considerable in commodity trade.As long as transport costs are high there is a large scoop for domestic price variations before it pays to import (export) the good from (to)an external market. When transport and other transaction costs, including tariffs, fall the band with its upper and lower limit within which domestic prices can vary will become narrow.For financial assets transaction costs are low and price differencesare therefore close to zero for identical assets traded in different markets.

For commodities a more adequate formulation of the law of one price is that the (absolute value) of the price difference between identical goods in two geographically separated markets is equal or smaller than the transport and transaction costs associated with bringing the commodity from one market to the other.If the two markets actually trade the good then the price differenceshould be strictly equal to transport and transaction costs. But if the good is not traded then price difference can be smaller.

Historically the major obstacles to the operation of the law of one price and to market integration have been tariffs, the high costs of transport and the unreliability and slow speed of information transmission. If you are not sure about the actual price at other locations it is too risky to trade. The law of one price operated first within regions and nations,and later in clusters of neighbouring nations.

There are two major implications of the law of one price. First,the price differencebetween identical goods traded in geographically separated markets will decline as transport and transactions costs and tariffs fall. This is called price convergence. Second, any deviation from the law of one price will prompt faster price adjustments so that the law of one price is restored. Both transport cost decline and increasing efficiency in information transmission are primarily 19th century phenomena.

Which are the economic mechanisms securing the law of one price? The short answer is trade and arbitrage. If it turns out that the price difference of a given commodity, say between Genoa and London, exceeds the transport and transaction costs it will be profitable for traders to import that good to Genoa. Doing so prices in Genoa will fall and prices in London might increase because of additional demand. By the mid 19th century all major cities in Europe were linked by the telegraph and if information was transmitted by the telegraphthe price difference would be knownwithin hours the same day. For that reason price adjustments will start immediately because there are usually inventories of goods in most markets in a trading network.Genoa merchants will therefore start selling their inventories anticipating shipments from London and a lower price inthe future. For that reason the price will start falling in Genoa before the new shipments arrive. If information travels by mail then the adjustment process will be slower simply because it takes longer for the information to reach merchants.A similar argument applies for the price of financial assets. If it is cheaper to borrow in London rather than Milanspeculators will borrow in London rather than in Milan and interest rates will increase in London and fall in Genoa as a consequence integrated capital markets with few restrictions on capital mobility will tend to have converging rates of interest.

Labour markets stand out as peculiar because restrictions to mobility are and have been more persistent than for capital and commodity markets. That is also a major reason why the convergence of wage levels across nations is more subdued. However, persistent wage differences remain because labour varies in skills, human capital, access to physical capital, in short productivity. The law of one price applies only to strictly identical commodities or factors of production.

Globalization means a high inter-dependence of domestic and global price and interest rate movements. It reduces the price setting market power of domestic industry as well as the power of trade unions to set nominal wages and to negotiate costly improvements in working conditions.In a globalized world the negative link between domesticlabour costand employment is stronger than in a less open economy.The mechanisms at work areset out in Figure 12.1. Consider an industry in an economy with a downward sloping demand curve for labour and an upward sloping labour supply curve. The demand curve for labour, D, is actually derivedfrom the demand curve for the products produced by the industry. When this economy is undergoing a process of globalization the demand curve for its products and hence labour is turning counter-clockwise and is becoming flatter, in technical jargon, it becomes more elastic as it shifts fromDD toD’D’.

Figure 12.1.Globalization means a stronger inverse link between domestic production costs and employment.

The reason is that demand for the industry’s products and consequently labour will be increasingly sensitive to changes in wages and hence prices as competition in creases. If trade unions increase wages, a shift in the supply curve from SS to S’S’, the negative effect on employment will be much larger in a globalized economy with labour demand curve D’D’ than in an economy under less international competition with labour demand curve DD. The employment effect will be 0L’ - OL’’. This argument holds under the ‘all other things equal’ condition. A wage increase which is a compensation for a rise in labour productivity does not shift the labour supply curve upwards at all, if you think of the wage as the wage paid per effective labour input per hour.You should not rush to the conclusion that globalization imposes a welfare losses on economies because of the unemployment risk.However, globalization constrains the bargaining power of trade-unions simply because it limits the market power of firms.

12.2. What is driving globalization?

The discussion in the previous section indicatedthat the major breakthrough of globalization takes place in the 19th century and is concentrated in its second half even if there are tendencies of price convergence in the World Economy already in the 17th and 18th centuries.Which were the forces who were drivingmarket integration and globalization? The short answer is politics and technology. On the policy side tariff policy, financial market deregulation and immigration policy were paramount. But economic policy is the subject of political processes of advances and retreats. Globalization has its winners and losers and the balance of pro- and anti-globalization forces have shifted in history. Periods of trade liberalization are interrupted by free trade backlash leading to protectionist legislation as explored in Chapter 8. The basic reason is that trade liberalization makes prices converge which alters the competitive position of domesticproducers. Scarce factors of production which, because of their scarcity, have been well rewarded in the past lose from free trade. The adjustment required involves structural changes forcing people off their land or jobs before they find new jobs in new occupations. There has been, however, a general drift towards free trade since WWII and the 70 years before WWI. The European external tariff level for manufactured goods is lower now than any time in history, and has been abolished entirely within the European Union, while agricultural protection remains high towards non-European exporters and higher than before 1930.. Capital market openness has also been contested repeatedly because it constrains monetary policy of governments.

The technological factors contributing to globalization are primarily those linked to transaction and transport costs. Transport costs fell in the 19th century but it is not clear that they have fallen since. The most dramatic transport cost reduction has not been in the transatlantic freight rates but in domestic railway rates. Previously landlocked areas in the Americas and Russia were linked to ports in the second half of the 19th century which made areas such as the US Midwest part of the world economy.

Figure 12.2 suggests that real transatlantic freight rates over the last 150 years have varied but there is not a clear trend. However railway rates declined dramatically in the 19th century.

(Marc this is a copy of a Figure, but you can generate the figure from data . Paul has the data!)

Figure 12.2.Real domestic (US rail) and transatlantic freight rates, 1850-1990. (1884=1)

Note: Real freight rates are measured as so called freight factor, which in this case are nominal freight rates for wheat deflated by nominal wheat price.

Source: Data from G.Federico and K.G.Persson, ‘Market integration and convergence in the world wheat market 1800-2000’ in T. J. Hatton,K. H .O’Rourke and A.M. Taylor (eds.) The New Comparative Economic History, Essays in Honour of Jeffrey G. Williamson,Cambridge: MIT Press, 2007, p.99.

Information transmission costshave fallen since the early 19th century at the same time as speed has increased. Information speed is important since much of the price adjustment in global markets is driven by new information about commodity prices. The major technological breakthrough in information technology was the telegraph which connected major European markets by the mid 19th century and by the early 1870s the whole world was ‘wired’. Before the telegraph information travelled at about the same speed or slightly faster than commodities. As the costs fall the accessibility of information also increased which improved the efficiency of markets. If information is hard to get it might remain private. If trade takes place withinsiders not sharing information the risk of collusion is large. In the second half of the 19th century a commercial press developed which published telegraphically transmitted information. In 1870 a merchant in a small city in France could read Echo des Halles, a daily with commercial news, and have information about yesterday’s prices and market conditions in St Petersburg, Berlin,Chicago and Buenos Aires. While 21st century technology permits instant access to information the great leap in information transmission technology was from private information transmitted by postal services to telegraph and the emergence of a specialized commercial press in the mid 19th century.

12.3. The phases of globalization.

There are threeimportant characteristics associated with market integration: price convergence,faster price adjustment in the domestic economy to world market events and finally an increase in the volume of trade, in capital flows and migration flows. By looking more closely at the timing of these indicatorswe can get a better picture of the globalization processin recent history and we will investigate capital markets, commodity market s and labour markets separately.

12.3.1. Capital markets

Currency markets existed on a European level since early medieval times and moneychangers in major trading spots were well accustomed to deal with hundreds of different coins. The bill of exchange developed to settle imbalances in trade between markets and became an instrument of credit. But was arbitrage efficient in that identical assets earned the same return (profit) at different locations? To answer that question you need a lot of detailed and frequent data which is not readily available. However, for some major financial centres, such as London and Amsterdam in the 17th and 18th centuries, we can actually test how efficient arbitrage was. Both markets traded shares in the East India Companies, for example, and it turns out that not only were price movements highly correlated but furthermore there were no systematic unexplained price differences between the two markets for identical assets. However, London and Amsterdam were the leading financial centres in the 18th century with frequent and well functioning postal dispatches linking the two cities. We cannot draw the conclusion that smaller and peripheral financial markets were as well integrated.

The advent of transcontinental telegraphs in the 1860s and 1870s created the pre-conditions for global capital markets. Information now travelled by minutes and hours rather than by weeks.

The major advantage of international capital flows is that domestic investments need not be constrained by domestic savings. Nations with large investment needs but with low income and savings can therefore borrow to invest. It is important to stress that the impact of globalization here is to relieve economies of a potentially harmful effect on growth of insufficient savings. One measure of capital market integration is therefore the absolute size of the current account* or net exports (exports minus imports). There is a downside, however. Although it is believed that international capital markets discipline high spending governments which borrow instead of taxing its citizens, history provides abundant examples of governments which default on international debt. Global capital markets allow current account deficits or surpluses as a share of GDP to be large.Most latecomers to industrialization benefited from foreign borrowing in their drive towards modernization at the end of the 19thcentury and the last third of the 20th century. Looking at the historical record the pattern of the current account (as a share of GDP) increased in the 19th century to reach all time high levels before 1914, around 6 to 8 per cent of GDP, only to decline in the Interwar period. Current accounts remained low for a large part of the post WWII period but increased again after capital market deregulation in the 1980s. Surprisingly, however, the link between domestic saving and domestic investment has remained strong, which is a bit puzzling. In a global capital market an increase in domestic savings should not necessarily impact upon domestic investment. Capital should flow to where rewards were highest, but there is a home bias in investment behaviour which might be explained by information asymmetries. That is, domestic investors are better informed about home market conditions than about foreign markets, to the extent that they might foresee profitable opportunities abroad. When investigating the time profile of the home biasit turns out that the pre-1930 period was the more globalized with outward looking investors. However, the Great Depression and the breakdown of international capital markets restored a strong link between domestic investment and domestic saving. Only in recent decades has that link been weakened, so that about 25 percent of a savings increase is heading abroad as against over 40 per cent in the first globalization phase before the Great Depression.

A consequence of a less globalized capital markets was that current account imbalances, positive or negative, were smaller and short-lived. Economies in the period before 1914 were permitted to run current account deficits for long periods. The Scandinavian countries and Russia, to name a few, did so before 1914. Although current accounts (the absolute value as a share of GDP) are typically smaller and transitory today gross capital flows are much larger after 1980. In the first globalization period nations were typically either debtors or creditors, with UK, France and Germany as the major creditors and Russia, Scandinavia, the UKEmpire and Latin America as major debtors. In the present era nations typically have foreign liabilities as well as foreign assets, that is residents in a nation, say, Germany, own assets in foreign countries but foreign residents also own assets in Germany. The magnitude of the flows, specifically of short term capital is causing problems for developing economies. Latin America and East Asia were troubled by large fluctuations in foreign investments in the late 1990s which had severe negative macroeconomic effects. As a consequence a more sceptical view as to the merits of unregulated capital markets has emerged since it was demonstrated that economies which hadimplemented capital controls managed the crisis in a better way.