Inequality and Globalisation

["Brown, Martin - ARP (NCI)" <mbrown@xxxxxxxxxxxx>]

Wisdom from NBER.....

NBER "Digest", September 2001
National Bureau of Economic Research

The Digest summarizes 4 to 6 recent NBER Working Papers
which are of unusual interest, timeliness, and newsworthiness.
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In this Issue:
  (1) How the Fed Responds to Stock Market Moves
  (2) Does Globalization Make the World More Unequal?
  (3) Lessons from the U.S./Canada Free Trade Agreement
  (4) Do Lending Booms Lead to Financial Crises?

Other issues are available at http://www.nber.org/digest.

(1) HOW THE FED RESPONDS TO STOCK MARKET MOVES

"An unexpected 5 percent increase in the Standard & Poor's 500 index hikes
by just over half the probability of a 25 basis point tightening at the
next Federal Open Market Committee Meeting."

Federal Reserve Board Chairman Alan Greenspan famously coined the term
"irrational exuberance" back in December 1996. His warning about the
economic risks associated with soaring asset prices set off a widespread
debate over whether America's central bank should deliberately prick what
appeared to be an emerging stock market bubble. Indeed, price-earnings
ratios skyrocketed until the bubble eventually burst in the spring of 2000.

Still, there are other broad questions besides whether the central bank
should target asset prices that appear to move away from fundamental
values. For instance, shifts in the stock market clearly influence the
direction of the macroeconomy. Does the Federal Reserve react to stock
market movements in setting monetary policy? And if the answer is yes, is
the Fed's policy response of the appropriate magnitude? These are the
questions that motivate Roberto Rigobon and Brian Sack in "Measuring The
Reaction of Monetary Policy to the Stock Market"
(http://papers.nber.org/papers/W8350).

The stock market influences the real economy of goods and services through
two main channels. The first is the so-called wealth effect. The total
financial wealth of American households stood at a staggering $35.7
trillion at the end of 2000, and stocks accounted for $11.6 trillion of
that sum. Consumers might open their wallets a bit more when stock prices
are rising smartly, but take fewer trips to the mall if falling stock
prices are cutting into household wealth. A bull or bear stock market also
affects the cost of financing for business. Last year, U.S. non-financial
corporations raised some $118 billion in equity offerings and more than
$100 billion in venture capital funds. This year, the comparable figures
are much lower.

Of course, teasing out monetary policy responses to the stock market is
difficult, especially since the stock market reacts to changes in monetary
policy even as that policy responds to shifts in the stock market. But the
authors are able to establish a relationship between monetary policy and
stock prices

Specifically, they find that an unexpected 5 percent increase in the
Standard & Poor's 500 index hikes by just over half the probability of a 25
basis point tightening at the next Federal Open Market Committee Meeting.
The same calculation works for a monetary easing. In other words, if the
probability of a monetary easing were 30 percent under existing economic
conditions, an unexpected 5 percent decline in stock prices would increase
the probability of a cut in the Fed's benchmark short-term interest rate to
80 percent. "This reaction is roughly of the magnitude that would be
expected from estimates of the impact of stock market movements on
aggregate demand," say the authors. "Thus, it appears that the Federal
Reserve systematically responds to stock price movements only to the extent
warranted by their impact on the macroeconomy."  (Chris Farrell)

(2) DOES GLOBALIZATION MAKE THE WORLD MORE UNEQUAL?

"The nations that gained the most from globalization are those poor
countries that changed their policies to exploit it, while the ones that
gained the least did not, or were too isolated to effectively change
economic and political policy... An integrated world economy would be less
unequal than today's barrier-filled, partly globalized world economy."

The world economy has become more unequal over the last two centuries. That
inequality is characterized by widening economic gaps between nations, but
not necessarily within nations. During this same period, the world economy
has become more integrated globally. This leads some economists to suggest
a relationship between global economic integration and economic inequality.

In "Does Globalization Make the World More Unequal?"
(http://papers.nber.org/papers/W8228), authors Peter Lindert and Jeffrey
Williamson find that increasing globalization has probably mitigated the
effects of inequality between nations that participate in global markets.
The nations that gained the most from globalization are those poor
countries that changed their policies to exploit it, while the ones that
gained the least did not, or were too isolated to effectively change
economic and political policy.

In analyzing economic data from 1820 to the present, the authors reach five
conclusions. First, the dramatic widening of income gaps between nations
probably has been reduced by globalization of commodity and factor markets,
at least for countries that integrated into the world economy. Second,
within labor-abundant countries before 1914, opening up to international
trade and factor movements lowered inequality. Third, within labor-scarce
countries prior to 1914 opening up to international trade and factor
movements raised inequality, a powerful effect where immigration was
massive. Fourth, all effects considered, more globalization has meant less
world inequality. Fifth, world incomes would still be unequal under a
scenario of complete global integration, just as they are in any large
integrated national economy, such as those of the United States or Japan.
But, they would be less unequal in such an economy than they would be in
one that is fully segmented.

Citing huge integrated economies such as those found in the United States,
Japan, and the European Union, the authors consider whether a corresponding
huge world economy with only negligible barriers to trade, migration, and
capital movements would make for a more unequal world economy. They
conclude that such an integrated world economy would be less unequal than
today's barrier-filled, partly globalized world economy.

The authors acknowledge the fear that many have that such a globalized
world would have vast regions with inferior education and chaotic legal
institutions and would be more unequal than societies found in economies
such as the United States or the European Union. However, the authors
conclude that the source of that inequality would be poor government and
non-democracy in the lagging countries, not the effects of globalization.
(Les Picker)

(3) LESSONS FROM THE U.S./CANADA FREE TRADE AGREEMENT

"The tariff cuts boosted labor productivity (how much output is produced
per hour of work) by a compounded annual rate of 2.1 percent for the most
affected industries and by 0.6 percent for manufacturing as a whole."

There is good news and bad news in regard to the Canada/U.S. Free Trade
Agreement (FTA). The good news is that the deal, especially controversial
in Canada, has raised productivity in Canadian industry since it was
implemented on January 1, 1989, benefiting both consumers and stakeholders
in efficient plants. The bad news is that there were also substantial
short-run adjustment costs for workers who lost their jobs and for
stakeholders in plants that were closed because of new import competition
or the opportunity to produce more cheaply in the south.

"One cannot understand current debates about freer trade without
understanding this conflict" between the costs and gains that flow from
trade liberalization, notes Daniel Trefler in "The Long and Short of the
Canada-US Free Trade Agreement" (http://papers.nber.org/papers/W8293).
"This paper," he writes, "does not provide the silver bullet that makes the
case either for or against free trade." The central tenet of international
economics is that free trade improves economic welfare. "Yet the fact of
the matter is that we have one heck of time communicating this to the
larger public, a public gripped by Free Trade Fatigue." The FTA, he writes,
provides a unique window on the effects of trade liberalization because it
was an unusually clean trade policy exercise, not bundled into a larger
package of national economic measures or market reforms.

His paper looks at the impact of the FTA on a large number of performance
indicators in the Canadian manufacturing sector from 1989 to 1996. In the
one-third of industries that experienced the largest tariff cuts in that
period, ranging between 5 and 33 percent and averaging 10 percent,
employment shrunk by 15 percent, output fell 11 percent, and the number of
plants declined 8 percent. These industries include the makers of garments,
footwear, upholstered furniture, coffins and caskets, fur goods, and
adhesives. For manufacturing as a whole, the comparable numbers are 5, 3,
and 4 percent, respectively, Trefler finds. "These numbers capture the
large adjustment costs associated with reallocating resources out of
protected, inefficient, low-end manufacturing," he notes.

Since 1996, manufacturing employment and output have largely rebounded in
Canada. This suggests that some of the lost jobs and output were
reallocated to high-end manufacturing. On the positive side, the tariff
cuts boosted labor productivity (how much output is produced per hour of
work) by a compounded annual rate of 2.1 percent for the most affected
industries and by 0.6 percent for manufacturing as a whole, Trefler
calculates. The tariff cuts raised "total factor productivity," a measure
that takes account of capital input as well as labor input, by a compounded
annual rate of 1 percent for the most affected industries and by 0.2
percent for manufacturing as a whole. Trefler figures this is attributable
to a mix of plant turnover (closings, openings, takeovers) and rising
technical efficiency within plants. It is not because of plants being
bigger, or a shift in market share toward firms with already high
productivity. In low-end manufactures, productivity rose sharply.

Surprisingly, Trefler writes, the tariff cuts raised annual earnings
slightly. Production workers' wages rose by 0.8 percent per year in the
most affected industries and by 0.3 percent per year for manufacturing as a
whole. The tariff cuts did not effect earnings of higher-paid
non-production workers or weekly hours of production workers. Thus, the FTA
reduced inequality in incomes, albeit minimally.

Between 1989 and 1996, U.S. exports to Canada of products of the most
affected industries increased 70 percent. The tariff cuts, reducing the
barriers to goods from the United States, account for three quarters of
that increase. Also, the tariff cuts explain about a third of the increased
share of imports from the United States in total Canadian imports from all
countries, from 85 percent to 90 percent. Trefler concludes, "Most of the
effects of the FTA tariff cuts are smaller than one would imagine given the
heat generated by the debate."  (David R. Francis)

(4) DO LENDING BOOMS LEAD TO FINANCIAL CRISES?

"Lending booms do make Latin American economies considerably more volatile
and vulnerable to banking and balance-of-payments crisis. The probability
that a banking crisis and a balance of payments/currency crisis will follow
a lending boom is twice as high in Latin America than in the rest of the
world."

Lending booms have been used to explain many banking crises, including
Chile's in 1982, Mexico's in 1994, and Thailand's in 1997. In each case,
reliance on foreign capital led to financial disturbances that combined
banking crises with a balance-of-payments collapse. The experience of
lending booms had led some academics and practitioners to advocate the use

of controls on short-term capital inflows or on private credit growth. Even
the International Monetary Fund has been moved by recent experience to
acknowledge the benefits of targeted capital controls.

But are lending booms really that bad? According to Pierre-Olivier
Gourinchas, Rodrigo Valdés, and Oscar Landerretche, writing in "Lending
Booms: Latin America and the World" (http://papers.nber.org/papers/W8249),
the answer is a qualified no, with Latin America standing out as the
exception.

A lending boom is defined as a period when the ratio of private credit to
private gross domestic product deviates from its historical trend. During a
boom, credit to the private sector increases rapidly. The danger is that as
lending increases, the quality of funded projects declines, and the banking
sector becomes more vulnerable. However, Gourinchas, Valdés, and
Landerretche show that the presumption that lending booms generically lead
to banking crises is wrong. While a lending boom may precede most banking
crises, banking crises do not follow most lending booms. Financial
development typically occurs in stages, with periods of intense financial
deepening and increases in the level of financial intermediation by banks.
Large increases in lending may represent a permanent capital deepening
rather than just a transitory boom.

The authors use two measures of lending booms, a relative measure that
compares the size of additional lending to the size of the banking sector
and an absolute measure against the size of the economy. Their study is
based on data for 91 countries, over the period 1960-96. The number of
lending booms identified depends on the size of the threshold used in
measuring deviation from the norm. Using a relative deviation of 24 percent
or an absolute deviation of 5 percent, there are 60 and 65 cases
respectively. Using relatively high thresholds of 42 percent and 8 percent,
there are 23 and 33 cases respectively.

Argentina, for example, experienced two lending booms (from 1979-82 and
1992-5) with the credit/GDP ratio increasing by 100 percent in the first
episode and by 70 percent in the second episode. Chile experienced a long
lending boom between 1975 and 1984, where the ratio increased by 1,200
percent. Mexico experienced a lending boom from 1988 to 1994, with the
credit/GDP ratio increasing by 350 percent.

The researchers find that lending booms are associated with: an investment
boom and to a lesser extent a consumption boom; declines in trend output
growth over the episode of over 1 percent; a large increase in domestic
interest rates; a large increase in the current account deficit and a
counterpart in the form of capital inflows; a real appreciation of the
domestic currency; some worsening of the fiscal situation; a decline in
foreign reserves; and a shortening of the maturity of the external debt.

However, the authors find no significant increase in banking and
balance-of-payment vulnerability. Nor do they find any evidence that
lending booms--which last an average of 6½ years on the relative measure
and 5½ years in the absolute cases -- tend to come to an abrupt halt.

To analyze whether boom episodes are related to financial crises - and
particularly whether they signal future banking troubles - the researchers
compare the probability of having a banking crisis before and after a boom
with the probability of experiencing a crisis during more tranquil periods.
They find that the probability of a banking crisis after a lending boom is
relatively low. Although the probability of a banking crisis up to two
years after a lending boom is somewhat higher than during tranquil periods,
the difference is not statistically significant.

Comparing Latin America's experience with that of the rest of the world,
however, the researchers find that lending booms do make Latin American
economies considerably more volatile and vulnerable to banking and
balance-of-payments crisis. Latin America has experienced a sharp increase
in lending booms during the 1990s.

The researchers show that capital inflows are more relevant before the
lending booms in Latin America than in the rest of the world; this fits
with the fact that a number of Latin American countries experienced capital
account liberalization during the sample period. Latin American lending
booms have been built around financial deregulation, capital account
liberalization, large capital inflows, and failed exchange rate-based
stabilization policy. The probability that a banking crisis and a balance
of payments/currency crisis will follow a lending boom is twice as high in
Latin America than in the rest of the world.  (Andrew Balls)


(The name of the freelance journalist who wrote the summary
appears in parentheses, at the end of the summary.)

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