Add in the fact that most people are highly dependent on income from their home country's labor market and investors' low levels of international diversification (home bias, as discussed in chapter 2), seems even more troubling.7 Yet World 2.0 overlooks diversification opportunities because it misses cross-country differences, and World 1.0 doesn't even look to other countries as a source of safety, seeing integration only as a source of danger. In that sense, World 3.0 does explicitly identify risk-related (potential) gains from globalization that prior worldviews do not.
In order to think even more broadly about integration and risk, it is useful to focus explicitly on interdependence. To start at a personal level, getting connected to the right people in the right way makes our lives richer and safer, but bad entanglements produce enough grief to keep screenwriters and novelists employed in perpetuity. Human progress since World 0.0 has been marked by increasing interdependence, supported by a host of institutions that make reliance on others less risky: cultural norms, courts of law, insurance markets, welfare protections, and so on. The task of this chapter is to shed some light on the risk implications of international economic interdependence so that we can shape integration to make World 3.0 not only more prosperous but also safer.
Managing interdependence, as in figuring out whom we should depend on for what as well as the commitments we can prudently make to others would be much simpler if we could accurately predict the future, or at least always understand the present correctly. The lack of crystal balls in the real world is a source of market failure that complicates the question of whether or not to link up volatile markets. So this chapter starts with background on informational imperfections and how they relate to market volatility. It goes on to look at how macroeconomic volatility has evolved as levels of integration have increased and the related worry of macroeconomic contagion—importing a recession or depression. It then examines the risk implications of cross-border flows of different types of capital and of food grain staples—two specific but challenging market arenas in the context of risk. The chapter concludes by returning to the broad relationship between integration and risk and offering recommendations for how to make globalization safer.
Informational Imperfections
The fact that we can't know the future for certain doesn't necessarily make markets fail. Chicago School economists, most notably Robert Lucas, espoused the “rational expectations hypothesis,” which says that everybody essentially optimizes their choices based on forecasts incorporating all available information. If that hypothesis were true and we all operated like little supercomputers, instantly processing humanity's cumulative knowledge, then in the absence of any other sources of market failure (like concentration and externalities, which we explored in the last two chapters), we could trust that prices would always transmit the right information to producers and consumers to guide them toward efficient deployment of society's resources. But as we'll see, reality often differs markedly from that utopian hypothesis, causing prices to diverge from fundamentals, boosting volatility and wasting scarce resources.
Consider the experience of deciding how to invest your retirement savings. Suppose you own a particular stock. The firm's CEO knows much more than you about the firm's strengths and weaknesses—what economists call an “information asymmetry.” In fact, you might decide to sell shares if you learn that the CEO just sold some of hers. If others do the same, the stock price tumbles, even if the CEO's share sale reflected nothing about the firm at all (maybe she just wanted cash to buy a new home). Conversely, if the firm buys back some of its own shares, this might send a positive signal. In both cases, the firm's stock price may swing sharply without any real change in its “fundamental” value.
Information asymmetries are just one information problem among many. Another factor contributing to volatility is the difficulty investors have figuring out what to do with all the information they do have. Few can conduct even rudimentary financial analyses, leading economists to peg them as possessing only “bounded rationality.” If you think you can get around this by hiring a financial advisor, then you have to wonder whether he or she is operating in your best interest or not, a “principal-agent problem.” And any serious effort at figuring out what to do takes time and money, a “transaction cost” comprised, in part, of “search costs.” The salience of the latter was highlighted by the selection of three of the leading thinkers in search theory for the 2010 Nobel Prize in Economics.
Keynes likened financial markets to a beauty contest where the way to win is to predict the other judges' opinions rather than to assess the contestants' beauty yourself.8 Even professional investment managers can gain by following the crowd against their own better judgment. As Jeremy Stein explained, “The underlying idea is that if you do something dumb, but everybody else is doing the same dumb thing at the same time, people won't think of you as stupid, and it won't be harmful to your reputation.”9 Think about your own financial decisions. Do you really make independent choices? According to Robert Shiller, “investing in speculative assets is a social activity” where “attitudes or fashions” can shift around much like they do “in many other popular topics of conversation, such as food, clothing, health, or politics.”10
Distance, furthermore, can exacerbate informational problems. We've already seen how foreign news provides a very limited diet of information to the general public. Worse, professional investors get tripped up even by within-country internal distance. A recent study found that “the average [mutual] fund manager generates an additional return of 2.67 percent per year from her local investments (defined as holdings within 100 kilometers of the fund headquarters) relative to her nonlocal holdings.”11
There are also indications that speculative activity might be making such problems worse. In volatile markets, the ability to hedge risk via the use of derivative contracts is very useful, but speculation can also increase volatility. It's hard to specify the balance, but the fact that the notional value of the world's derivative contracts (some $615 trillion in over-the-counter markets alone) far exceeds its total financial assets gives some sense that derivatives are being used for a lot more than hedging real risk exposure.12 And the rapid growth of high-frequency trading, now accounting for some 60 percent of U.S. and 40 percent of European stock market volume, is another worry.13 Computerized trading algorithms that buy and sell their positions multiple times per day have been pinned as a likely contributor to the twenty-minute “flash crash” of May 6, 2010, that temporarily erased $1 trillion of market value.14 Economist Joseph Stiglitz, who won the Nobel Prize for his work on information asymmetry, commented, “I think a number of us are coming to the view that this high-frequency trading has negative social value, and that it's not information discovery.”15
Thus, informational imperfections can contribute to herding, bubbles, and of course volatility. But such problems don't plague all markets equally, nor do imperfections in all markets pose similar levels of danger to the general public. Consider the market for euros versus the market for this book. Both currency traders and my publisher operate under conditions of uncertain demand. But the euro, traded on liquid markets, supplied according to European Central Bank policy, and valued from an individual holder's perspective almost entirely based on other traders' expectations, is a much more attractive target for speculation. Even if after reading this book, you think it's going to be a runaway best seller, I can't in good conscience advise you to start hoarding copies to profit from a speculative bubble. You'll have a hard time offloading them, and soon enough the publisher will be on the scene with another printing. Publishers adjust supply to maximize profits; central banks don't. To my regret, this book will never be something readers really can't do without if it temporarily goes out of stock. And if this book is mispriced, the effects won't spread beyond the submarket of related books. Not so for the euro.
This is just one way of illustrating that most product markets are not subject to the full extent of
the informational problems and volatility on which this chapter focuses. So, as we turn to the potential dangers of connecting markets across countries, with a particular focus on capital and food markets, there should be some comfort in remembering that you don't have to worry about similar problems affecting most of what you buy on a daily basis. The cases focused on here are particularly hard ones.
Present Tense, Past Perfect?
As of this writing, most of us are still pretty dazed by the last few years of macroeconomic instability, but it's important to avoid what psychologists call the “recency bias” and put present conditions into longer-term perspective. The broader trend is that as cross-border integration increased in the latter part of the twentieth century and early twenty-first century, volatility generally declined, to the extent that this period has been termed the “Great Moderation.” Thus, the volatility of U.S. aggregate income from 1984 to 2004 was roughly one-half the average for the period from 1960 to 1983.16 More broadly, macroeconomic volatility has declined in most major industrial economies since the mid-1980s and “output volatility seems to have been on a declining trend in emerging markets and developing countries as well.”17 This should provide some reassurance that globalization doesn't inevitably lead to macroeconomic instability.
What about stock market returns? It can be scary to watch how what happens in U.S. markets impacts Asian markets, whose trends carry over to Europe, and so on, around the clock. Returns have become more correlated across countries since the 1970s,18 but several offsets are worth citing. Taking the long view, correlations have fluctuated widely over the past 150 years instead of increasing monotonically. In fact, stock markets were more closely correlated during the great depression than in the late twentieth century, as shown in figure 7-1.19 In the 2000s, correlations did increase with global financial flows in the run-up to the global financial crisis (with the worst of the crisis obviously marking a period of very high correlation), but they remain far from perfect and may yet decrease with the financial slowdown if the decades-long declines after prior peaks are any guide. And stock market correlations also continue to reflect distance effects.20 So while higher levels of correlation imply less risk reduction potential from international diversification, there still does seem to be significant potential.
How can we square this seemingly benign pattern with our worries that connecting volatile markets increases systemic risk? A good starting point is to note that while contagion really can happen, it is usually moderated by the law of distance. Thus, when Greece got into a full-blown crisis around the state of its public finances, it was a problem more for the Eurozone than for the whole world. And within the Eurozone, financial markets focused on whether “Aegean contagion” would spread to other southern European countries judged to be relatively similar to Greece along the CAGE dimensions. As the very term contagion implies, distance still matters, and contiguous or near-contiguous countries are usually at greater risk. Figure 7-2 makes the same point in the context of real rather than financial contagion.
Figure 7-1: Average correlation of capital appreciation returns for all available markets, 1860–2000
Correlations based on rolling window of 60 months. Number of countries covered rises over time from 4 in 1860 to roughly 50 by 2000, reflecting the development of stock markets in more countries and improvements in data availability.
Source: William N. Goetzmann, Lingfeng Li, and K. Geert Rouwenhorst, “Long-Term Global Market Correlations,” DNB Staff Reports, no. 09/2003.
Numerous other historical examples also highlight the relationship between geographic distance and contagion. The “tequila effect” spread Mexico's 1994 crisis to Brazil and beyond. The 1997 Asian crisis spread from Thailand to Indonesia and then later to much of Asia before hitting Russia in 1998. And in terms of economic distance, note that individual countries' GDP growth has become less tightly tied to global trends and more tightly tied to patterns in other countries at similar levels of development, generating discussion of “decoupling” or growing distance between developing and developed countries.21
Figure 7-2: Sensitivity of GDP growth trends to distance: Estimated impact of a 1% decline in U.S. GDP growth on other countries and regions
Sources: Based on figure 4.5 of Thomas Helbling, Peter Berezin, Ayhan Kose, Michael Kumhof, Doug Laxton, and Nikola Spatafora, “Decoupling the Train? Spillovers and Cycles in the Global Economy,” chapter 4, in IMF, World Economic Outlook, 2007.
To summarize, we see evidence that macroeconomic trends—regional or global, coupled or decoupled—do cross national borders to an extent that can usefully be parametrized in terms of distance sensitivity. But if we want to reverse cross-border integration enough to stop the transmission of financial shocks, in particular, across countries, we'd have to go back at least to World 1.0, and probably to a pretty extreme variety of it (close to autarky). Such shocks (and their real correlates) have been transmitted around the world through major financial centers for at least two hundred years now, so tinkering with globalization around the edges seems unlikely to stop contagion.22 In part, that's because real flows aren't the only ones that spread crises; fear and confidence play a role, and tariffs or capital controls can't stop them from leaping borders.
Furthermore, any World 1.0-inspired attempt to curtail integration enough to eradicate contagion would also mean forgoing outside sources of stabilization and growth. Quarantine might seem appealing, but don't forget that the “growth bug” is also contagious. What would Greece's prospects for recovery be without foreign capital and tourists? What about bailout-weary Germany without the third of its GDP generated by exports? Not that World 2.0 is any better. False perceptions of complete integration contribute to the contagion problem. Fear flies across borders far faster than fundamentals. If we really stop to understand cross-country differences, we'll be less likely to mistake Korea for Thailand, or Spain for Greece.
Some contagion is inevitable, but it's conditioned by distance, and long-term trends provide comfort that integration does not necessarily cause macroeconomic instability. We don't have to abandon integration wholesale due to safety concerns. Rather, we should look to particular kinds of flows to shape integration more intelligently. Therefore, we turn next to specific worries about two broad categories of markets, for capital and for food grains, whose cross-border connections have stirred many risk-related discussions. Does World 3.0, with its emphasis on the differences between countries and the law of distance offer any help in thinking through these issues?
Capital Gains or Capital Punishment?
Capital, like food and oxygen for living bodies, is the lifeblood of a market economy. When capital markets are functioning well, they may seem as invisible as the air we breathe, but as we have been painfully reminded, when they seize up, even the healthiest among us start to choke. And as the section on informational imperfections described, capital markets are prone to extreme bouts of volatility. Thus, some careful analysis and reflection is called for before deciding whether or not we want to connect them across countries.
Advocates of opening up financial markets started off with the simple argument that with liberalization, capital would flow from rich to poor countries (where capital is scarcer), accelerating economic development in poor countries and providing high returns for investors. Such flows, however, turned out to be much smaller than models would predict—the “Lucas paradox”23—and recently we have seen large flows of capital “uphill” from poor to rich countries.24 Economists have since provided a variety of explanations for this phenomenon, ranging from “increasing returns to human capital” and “institutional failures” to “recurrent defaults and financial crises.”25
Another argument in favor of opening up capital markets relates to reducing consumption volatility. When ordinary people worry about economic risk, they're most concerned about sustaining consumption levels. Access to funds from foreign sources in times of trouble should help countries to smooth consumption
while domestic output fluctuates. In fact, there is evidence that developed countries do share risk in this way, that emerging markets have largely been unable to do so, and that there is potential for more international risk sharing among countries at all development levels.26 More recent arguments in favor of capital market liberalization emphasize indirect or “catalytic” benefits, such as spurring domestic financial maturity, strengthening institutions, and improving macroeconomic policies.27
On the other side of the debate, we find, in addition to incredulity, lots of counterarguments. Some detractors of open capital markets go so far as to accuse institutions like the IMF of pushing hard for liberalization not because it is good for developing countries, but because it benefits rich-country investors. Others emphasize how open capital markets can cause or worsen economic crises. An extensive literature has detailed the macroeconomic damage wrought when foreign capital surges into a country and then rushes out or slows. Capital flows to emerging markets overreact much as stock prices do. A country gets “hot” and money flows in. The longer the “bonanza,” the greater the chances of its ending in a “sudden stop”—a sharp decline or, even worse, reversal in capital inflows.28 To recall the adage about automobile accidents, it is the sudden deceleration that kills, not the speed.
Fallout from large shifts in capital flows can prove staggering. Countries often experience current account reversals, unless they can stave them off or soften them by spending down foreign currency reserves. Currency and banking crises follow, as do extended periods of slower growth. Even beyond the most violent cycles of bonanzas and sudden stops, volatile capital flows correlate with slower growth. However, these calamities shouldn't be blamed on capital flows alone; in most crises, they have formed part of a toxic mix of high foreign debt levels (often denominated in foreign currencies), inflexible exchange rates, domestic financial market imperfections, and so on, which is why one large literature review concluded that “there is little formal empirical evidence to support the oft-cited claims that financial globalization in and of itself is responsible for the spate of financial crises that the world has seen over the last three decades.”29
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