Insight: The pitfalls of financial globalisation grow clearer

Conventional wisdom has it that globalisation and the spread of deregulation have been an economic boon for the English-speaking countries.

Having run down their manufacturing as a percentage of gross domestic product in the 1980s and 1990s, the US and the UK have been less vulnerable to Chinese competition in this cycle than the big economies of continental Europe. And with disproportionately large financial sectors, these two countries have also enjoyed a financial windfall from the rise of China and other emerging markets.

New York and London have played a central and lucrative role in recycling the glut of savings in Asia and in the petro-economies. Much financial innovation in wholesale markets was spurred by this phenomenon.

At the same time equity markets have thrived as profits have risen to a record share of gross domestic product. Among other things this reflects the greater exposure of corporations to global market discipline and the benign disinflationary impact of millions of Asians coming into the global workforce.

Meanwhile, retail financial markets have hummed as cheap credit powered housing booms in the Anglo (and other) economies. But as the suddenly crisis-prone financial sectors of the US and UK now confront a second round of tightening in the inter-bank market, it is worth asking whether this financial bias could be too much of a good thing.

There is a risk of exaggerating the economic impact of the debacle in asset-backed paper markets in relation to large and diverse financial sectors. Yet systemic trouble in finance can have wider indirect consequences. With housing markets going into reverse in both countries, there is every likelihood that households will rebuild very low savings ratios. The consequences for demand could be nasty. With a much less diversified economy than the US and much greater debt as a percentage of household wealth, the UK looks the more vulnerable. Sterling has a looming problem.

In the longer run there is a risk that financial activity will be damped by rising inflation. While Chinese demand continues to put pressure on energy and raw material prices, it is no longer exerting such downward pressure on the price of global labour.

A more fundamental point is that China and other emerging market countries are unilaterally rolling back the high tide of liberalisation. Thanks to their rise, more of the world economy operates under mercantilist pegged exchange rate regimes. By investing their official reserves in developed world government debt, they reduce the cost of public sector borrowing, making a return of big government easier. As co-conspirators with the US Federal Reserve in creating the credit bubble, the same countries have contributed to a boom and bust cycle in housing and finance which will lead to a political backlash, soon to be followed by cumbersome regulation.

Meanwhile, sovereign wealth funds are indirectly reversing the privatisation trend that began in the 1980s through a re-expansion of state ownership, but on a cross-border basis. That in turn will spawn an illiberal political reaction that will inhibit global capital flows.

On the face of it, continental Europe ought now to be better placed to cope. Yet this is no time for schadenfreude. Two German banks that dabbled in subprime structured products have had to be rescued. The dabbling arose from an urgent need to raise returns in an over-politicised, over-regulated, but under-profitable German banking system.

With globalisation, no economic model provides protection from the excesses of someone else’s model. As conditions in the US mortgage market worsen next year, the waning ability of the US consumer to absorb the rest of the world’s goods will hurt everybody, including continental Europeans.

There is no question that smart, global finance has been a good thing. Without the recycling of capital, excess savings in Asia would have been profoundly deflationary. Yet from today’s global vantage point, we have undoubtedly all had too much of this good thing. Whether it is ever possible to have just the right amount is another question.