by William R. Cline, Peterson Institute for International Economics
Prepared remarks at the Peterson Institute event "The Globalization Paradox: Democracy and the Future of the World Economy"
May 4, 2011
It is always a pleasure to read Dani Rodrik's reliably provocative work. In this book, on finance he deftly casts doubt on the inevitability of current international arrangements by reviewing the past reversals in the international regime. He sets forth the major paradigm shift from free capital movement under the gold standard, to capital controls under Bretton Woods in order to provide the space for Keynesian stimulus following the Great Depression, then back toward financial opening. The recent peak in this pendular swing came in the 1997 attempt to rewrite the International Monetary Fund (IMF) articles of agreement to enshrine capital openness, which was exquisitely ill-timed to coincide with the initial phases of the East Asian financial crisis. Rodrik sounds remarkably nostalgic for the days of thin globalization under Bretton Woods, despite its unsustainability because of the Triffin paradox that the dollar could not be the source of rising international reserves while maintaining credibility on external trade balance, as well as its pillar of an overly negative Keynesian view of exchange rate flexibility. I was impressed to learn that the move toward what are now open capital markets in virtually all industrial countries gained momentum from a most peculiar source: the French Socialists. Mitterand's "experiment of socialism in one country" in 1981 prompted so much capital flight through indirect trade-invoicing mechanisms, despite currency controls down to the level of the carnet de exchange booklet for travelers, that by 1983 the French relaxed capital controls and moved toward the US-UK camp favoring open capital markets.
The central theme of Dani's vision is that free market orthodoxy can cause undue damage, and that it should be replaced by considerable national latitude that reflects nationally divergent needs and tastes that differ across democracies. To sharpen the point, in effect Dani wants to make the world safe for politicians like the 1987 Japanese minister of agriculture, who argued that Japan could not import beef because in Japan human intestines are longer than in other countries. My central problem with this vision is that it ignores the reality of today's global economy in which three dozen major economies accounting for 90 percent of global product interact in what amounts to a positive-sum repeat game constructed around the central dynamic of reciprocity. Dani's "different strokes for different folks" sounds plausible enough when considering whether a small, poor, African country should be allowed to experiment with infant-industry protection. It is surely implausible when asking whether there needs to be symmetry and reciprocity among such major economies as the G-7 on the one hand and the BRICs on the other.
In particular, Dani's application of the argument to China seems particularly misguided. He states that China needs an undervalued exchange rate to make up for its loss of autonomy in industrial policy suffered when China joined the WTO; otherwise its growth rate would fall by 2 percentage points. But part of the reciprocity deal in the WTO was that under Article XV, China would not "frustrate the intent" of its new obligations by engaging in "exchange measures." It is implausible that a shift from foreign to domestic demand would damage growth and employment as Dani asserts—indeed, a stronger exchange rate should shift demand toward more labor intensive activities—and even more unlikely that China would sacrifice democracy if that were to occur—his democracy trilemma.
A major problem with Dani's treatment of financial globalization is his tendency to attack straw men. He proposes that developing countries should have "policy space for them to manage international capital flows and prevent sudden stops and overvalued currencies" (p. 265). But where has it been written that they are not permitted to do so already? Indeed, Dani could claim victory and proclaim that the new IMF orthodoxy provides an official blessing to precisely this kind of flexibility, which in any event already existed. There were no WTO-like penalties against capital controls; just ask China and, in a less extreme form, Brazil. At best his approach says the current non-rules should be preserved into the future.
It is Dani's cavalier dismissal of gains from financial globalization that is the most troubling, however. He cites the case of China, a "growth champion" despite tight controls. Perhaps a 40 to 50 percent savings rate generated by China's unusually high retained corporate earnings contributed more to this outcome, however, than capital controls. He ignores the preponderant findings in the empirical literature that show positive rather than negative statistically significant effects of financial openness. As I showed in my book last year, of the dozen or so leading econometric studies, only one-half of one study obtained a significant negative effect (Sebastian Edwards's income threshold case). All of the other statistically significant results were positive. The chances of this occurring on a random basis are 1 out of 300. Even if the statistically insignificant results are included using the formal meta-analysis technique of inverse variance weighting, it still turns out that complete financial openness as opposed to closedness boosts average growth by one-half percentage point per year.
Dani emphasizes boom-bust cycles with sudden stops as prima facie evidence that openness is dangerous. It turns out, however, that banking crises and currency crises have actually tended to be more frequent among emerging market economies with the more closed capital markets rather than the more open ones. In my book I constructed a simple simulation model to compare the additional risks from openness against the secular growth gains. The result is that the chances were about 20 to 1 in favor of the secular growth gains outweighing the crisis losses, applying a range of damage estimates from such authors as Ken Rogoff, Carmen and Vincent Reinhart, and Hutchison and Noy.
Finally, Dani seems particularly misguided when he implies that in order for some countries such as the United States to have more rigorous capital adequacy rules for banks in the aftermath of the global financial crisis, it will be necessary to control capital movements. We already know that the Swiss will have considerably higher capital requirements, yet no one thinks it will suddenly be necessary for Switzerland to impose capital controls as a consequence. Dani may be right that Basel III will be watered down to the least common denominator. The proper conclusion, however, is that Switzerland and the United States may appropriately impose additional screens on foreign financial firms before permitting them to operate in their territories, not that the United States and Switzerland will need to impose capital restrictions.
In sum, Dani's book deserves to be widely read and debated, and I have every confidence that it will be.
Op-ed: The Payoff from Globalization June 7, 2005
Paper: The Payoff to America from Global Integration January 2005
Book: Has Globalization Gone Too Far? March 1997
Policy Brief 01-2: A Prescription to Relieve Worker Anxiety March 2001