The unintended consequences of globalization

I've been working on a post about the unintended consequences of globalization for a while now, and Wednesday's intervention in the foreign exchange market by the Bank of Japan gave me the motivation to finish and publish it. I have plenty more to say about the Bank of Japan's actions, but it may have to wait for a subsequent post. 

When I was an undergraduate economics major, the concept of globalization (and global specialization) seemed to be gaining traction by the day. Free trade agreements were popping up around the world--NAFTA and the World Trade Organization had come into existence just a few years earlier--and the works of Thomas Friedman were becoming ubiquitous in the academic world. The return of Hong Kong to Chinese sovereignty only added intrigue to the ever-growing discussion on the benefits of increased global interactions.

By the time I returned to school for my MBA in 2007, globalization had fully taken hold. A full third of my incoming Darden class consisted of international students, Friedman had earned wide accolades for The World is Flat, and the lesson in my classes was clear: in the 21st century, your business was either international or irrelevant.

But the global financial crisis of 2007-2008 laid bare the vulnerabilities that the interconnectedness of globalization had created, raising new questions as to the long-term viability of global business in the traditional sense.

The classic definition of globalization relies on the concept of "comparative advantage", which assumes that different countries will be able to produce certain goods at a lower relative cost than others. Comparative advantage posits that by specializing in those categories in which they have an economic edge, both nations can prosper and the overall economic level can rise--Chinese thrive by selling t-shirts to Americans, while Americans are free to focus their efforts on producing high-technology goods. (If you're unfamiliar with the theory, the Wikipedia link actually does a very good job of summarizing it).

But the problem with the theory of comparative advantage is that it is does not sufficiently allow for a dynamic world. It essentially assumes that the conditions which led to the existence of the relative advantages will remain static, and that neither side will hope to change them. In other words, it assumes that China will always be happy being a manufacturing-heavy society, providing cheap t-shirts to America, and that its labor rates in that arena will never increase.

Of course, proponents of globalization theory will argue that this is not the case--that a rising tide lifts all ships, and both economies will be able to grow and prosper. As the economies grow, their relationships will change, but the benefits outweigh the costs. The problem is, those frictional shifts in economies place incredible strains on existing trade relationships, and there will always be great resistance on one side or the other to a proposed change in the nature of the trade agreements.

As a result, economies on both sides of international trade become vulnerable. After years of the United States outsourcing its manufacturing jobs to India and China, India is left with a severe shortage of civil engineers, while the United States' manufacturing industry struggles to find workers to fill its jobs. This type of problem becomes exacerbated in times of recession, when domestic issues become of foremost concern.

Furthermore, shifts in the currency market (which has become increasingly more volatile) can be very dangerous to ongoing trade agreements. Facing a severe recession, the United States is under significant pressure to label China as a currency manipulator. The argument is that by artificially holding down the value of the yuan, China has unfairly distorted the labor market, stealing jobs from Americans by virtue of their weaker currency.

But the weak yuan has benefited both economies for decades, as it has been a fundamental factor in creating the "comparative advantages" enumerated above. Without a weak yuan, U.S.-China trade would have been essentially impossible. The weak yuan only became a "problem" when U.S. unemployment rates spiked to 10%, placing pressure on politicians to salvage as many American jobs as they could. When times are bad, we no longer want China to specialize in anything--we want all the jobs to ourselves.

We in America don't fully appreciate that if the yuan appreciates, both economies are in trouble--our labor force is not nearly nimble enough to take on these jobs, even if it becomes economically efficient to do so. You can't tell an unemployed iron worker to become a t-shirt fabricator overnight, any more than you can tell a chef to become a lawyer--at least not when you've spent decades training him to be what he has become. Worker mobility--in terms of both geography and industry--is incredibly low in the U.S., in large part due to the specialization that global trade created. This lack of employee mobility makes recoveries incredibly difficult.

The assumptions of a static world are always flawed. The developing countries want to become developed, but face resistance from those parties who benefit from their low labor rates. Currency exchange rates change drastically, with central banks fighting each other tooth and nail to either protect or change the status quo, depending on their individual motivations.

Ultimately, globalization becomes a dangerous game with dangerous international political implications. The gains from international trade are great for everyone in a booming economy. But once recession hits, all assumptions go out the window. China sees a unique opportunity to grow stronger relative to the developed economies, while the U.S. struggles to stay afloat and blames China (and its "currency manipulation" tactics) for its ailments.

All business partnerships--whether at the individual, corporate, or national level--depend on well-aligned goals and motivations to remain successful. The problem in the "global" world is that motivations can and must change with time, and frictional changes are messy. When one side has everything to lose, and the other everything to gain, there is no easy way out.

We can complain all we want today that China has all of our manufacturing jobs, and blame them for our stubbornly high unemployment rate. But the trade choices that we made over the last two decades--two very prosperous decades--created this mess in the first place. We cannot accept the gains from globalization without recognizing the risks. Unfortunately, the downside of globalization is all too much in our faces now. How we overcome this downside--and return to prosperity--is the most important policy decision we will have to make for the next decade and century.