The New Macro of Globalization

The New Macro of Globalization – at - the best of the week's international financial media.

Globalization is rewriting the script of some of our most time-honored macro relationships. That's true of the forces shaping employment, real wages, income generation, inflation, and trade and capital flows. On all of those counts, the rich countries of the industrialized world are under pressure as never before, as globalization spreads wealth and prosperity from the developed to the developing world. Courtesy of IT-enabled connectivity, this diffusion of economic activity is now occurring at hyper-speed. Economists, policymakers, workers, investors, and politicians don't comprehend these seismic shifts. This underscores the risk of a potential backlash against globalization.

As the most open and flexible economy in the developed world, the United States is on the leading edge of being exposed to the stresses and strains of globalization. The evidence is overwhelming that the current economic recovery is unlike anything America has ever experienced in the modern-day, post-World War II era. Job growth remains decidedly subpar: The May employment report was only the latest in a long string of disappointments on the US hiring front; by our reckoning, private nonfarm payrolls are more than 10 million jobs below the cyclical profile of the past five economic recoveries in the US. Moreover, inflation remains incredibly low: Despite all the talk of increased pricing leverage, mounting cost pressures, and a narrowing slack in labor and product markets, the core CPI has edged down in recent months and held at just a 2.2% y-o-y rate in April 2005.

At the same time, real wages remain in a mode of near stagnation -- not only tracking below the pattern of the typical business cycle, but falling far short of vigorous gains that should be expected from a high-productivity-growth economy. As a result, there has been an unprecedented shortfall of earned labor income -- the organic income generation derived from gainful employment. By our calculations, private sector real wage and salary disbursements -- fully 45% of US personal income and, by far, the largest piece of aggregate purchasing power -- remain $300 billion below the path of a typical recovery.

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Despite this profound shortfall of job creation, pay rates, and income generation, US domestic demand growth has remained amazingly robust. That's especially true of the American consumer, as personal consumption has soared to a record 71% of US GDP -- well in excess of the 67% norm over the 1975 to 2000 period. The vigor of consumption in the face of anemic income growth has been sufficient to push the personal saving rate down to the "zero" threshold -- leaving US households with little backstop at precisely the point in the life cycle of aging baby boomers when there should be a pickup in saving in order to prepare for retirement.

Income-short economies that consume beyond their means have to close the circle somehow. Two developments are at work in the US: First, the windfalls of the Asset Economy have supplemented household purchasing power. That's especially the case with property appreciation. Unfortunately, consumers have had to go deeply into debt to extract this newfound purchasing power from their increasingly over-valued homes. Second, with America's net national saving rate having fallen to a record low of 1.5% of GDP since early 2002, a saving-short US economy has had to import surplus saving from abroad to keep on growing. And it has had to run massive current account and trade deficits to attract that capital. With the trade deficit now at 6% of GDP and the current account gap at greater than 6.5%, America is more dependent than ever on the "kindness of strangers."

All of these macro anomalies reflect the telltale footprints of a new and powerful strain of globalization. Three new mega-forces are now at work in reshaping the world: First is what I have called the "global labor arbitrage" -- the increased integration of offshore employment pools that fundamentally alters the worldwide mix of job creation and wage determination (see my 5 October 2003 essay, The Global Labor Arbitrage). For most of the modern-day era, job and wage competition has been confined to the manufacturing, or tradable goods, sector. Now, courtesy of the Internet, real-time connectivity with offshore pools of low-wage, highly skilled knowledge workers has pushed the arbitrage into once sacrosanct services, or nontradable, sectors. The hyper-speed of this IT-enabled transformation of global nontradables is unlike anything seen in the past. Five years ago, it was concentrated at the low end of the value chain in data processing and call centers. Today, it is also occurring at the high end of the value chain -- software programming, engineering, design, and professionals in the legal, actuarial, medical, accounting, financial services, and a broad array of consulting occupations. Such offshoring activity is still small in terms of the absolute numbers of workers involved -- especially when scaled against the size of the developed world's work force. But it is now growing and spreading rapidly -- underscoring a powerful change at the margin that is rewriting the rules of employment and wage determination.

A second force at work is the "global price arbitrage." Gone are the days when inflation is driven by trends in domestic cost structures. As Dick Berner recently noted, the old cost mark-up models are relics of a once closed US economy and, as such, are hopelessly out-of-date; at work is what Dick calls a new "market-pricing paradigm" -- in effect, a price-setting mechanism that reflects the balance between global supply and demand (see Dick's 3 June 2005 dispatch, "Inflation Model Uncertainty"). Little wonder that the US inflation rate has continually surprised on the downside. Are price setters (or wage-setters) at the margin still in America? Or do they now reside in Guangzhou and Bangalore? Here, again, the Internet has played an important role in redefining long-standing macro relationships. IT-enabled cost- and price discovery has spread like wildfire in goods and services, alike -- adding an entirely new element to the global price arbitrage.

The "global saving arbitrage" is a third new macro force that is turning our old models inside out. It reflects a world that is near desperate in its efforts to keep funding the excess spending of the income-short American consumer. At today's level of the US current account deficit, that desperation takes the form of capital inflows into the US of approximately $3 billion per business day. Nor is this coming from private portfolio investors who are dying to get a piece of the excess returns of America's high-productivity economy. The bulk of these flows are now "policy buying" of foreign central banks -- especially Asian authorities, who feel compelled to maintain undervalued currencies in order to keep their externally-led economies growing. Fed Governor Ben Bernanke argues that America is doing the world a favor by consuming this saving glut (see Bernanke's 14 April 2005 speech, "The Global Saving Glut and the US Current Account Deficit," available on the Fed's website). I would maintain, instead, that the non-US world is asking for serious trouble by suppressing domestic consumption and fueling the excesses of the over-extended American consumer. This saving transfer breaks the mold of earlier globalization models. A global saving arbitrage that finds the consumption excesses of the world's economic leader being funded by poor countries such a China is the mirror image of trends that prevailed in the late 1800s and early 1900s -- when rich nations ran current account surpluses and transferred wealth to the world's "settlement".

A complex picture emerges out of this new and powerful strain of globalization. The cross-border arbitrage of labor, pricing, and saving renders traditional closed-economy macro models all but obsolete. Nor do these forces operate in isolation from one another -- there is a powerful interplay between the globalization of work, income generation, price-setting, and capital flows. America's Asset Economy is an outgrowth of this interplay. It is the principal means by which the world's most powerful economy has kept on consuming in the face of extraordinary pressures on jobs, real wages, saving, and debt.

At least for the time being, the saving-rich developing world has been more than willing to fund the massive current-account deficit that underpins America's Asset Economy -- providing capital inflows into the US that effectively subsidize real interest rates at historically low levels. The global price arbitrage that has been spawned by the emergence of low-cost production centers in the developing world helps keep inflation low, thereby reinforcing the staying power of this low interest rate regime. This then provides support to frothy financial markets -- the crux of the Asset Economy. Ultimately, both of these anomalies -- unsustainably low real interest rates and excess asset appreciation -- will need to be corrected in order to put the world on a more sustainable path. However, given the likelihood of a global slowdown made in China emerging over the next year, I now believe this correction will come later rather than sooner.

Unfortunately, for this Brave New World there is nothing stable about this arrangement. There are stresses and strains everywhere in the system, and the perils of political intervention are mounting. Rapidly escalating trade tensions between the US and China are the most obvious case in point. Washington ignores the new macro framework at great peril -- failing to appreciate that America's current-account and trade deficits are an unfortunate outgrowth of an unwillingness to save. China, for its part, paints itself into an equally difficult political corner by dubbing its currency issue a matter of national sovereignty. Meanwhile, as the Airbus dispute indicates, there is nothing tranquil about US-European trade relationships. And Europe is still reeling over its own intra-regional political shock, with the demise of the EU constitution very much an outgrowth of the same fears of job and income insecurity that are plaguing high-wage workers elsewhere in the developed world.

The biggest risk of all is that the new global macro could well give rise to a backlash against globalization. Mounting trade tensions are a very visible manifestation of how the body politic has lost confidence in the gospel of free trade and comparative advantage long espoused by most economists, including yours truly. Persistently subpar employment and real wage growth in the world's most powerful economy fuel that confidence loss. In effect, workers have lost patience with the promises of classic free-trade economics, and opportunistic politicians have seized on that angst. Globalization has met its demise in the past -- and the circumstance of that backtracking took the world right to the brink of World War I. Yes, history rhymes, rather than repeats. But the downside of a backlash against globalization is something we can't afford to take lightly. It would be the ultimate comeuppance for ever-blas financial markets.

By Stephen Roach (New YorkMorgan Stanley Economist, in the Global Economic Foru