Since 80 percent of the world’s economic weight is in the developed world, only problems at the top of the global economic tower can threaten to topple the tower itself. Third world economic problems are important because of the human suffering they represent, but they do not threaten the existence of globalization. There are many things the first world can and should do for the third world, but the most important of them is to insure economic prosperity in the first world. Without first world prosperity and the market opportunities that are generated by this prosperity, the third world has no hope of economic development.
Japan’s deflation has already spread to most of East Asia. In Europe, Germany would be in deflation were it not for all of its bureaucratic rules and regulations that prevent prices from falling. To find the real rate of inflation in Germany one must look at what is happening to prices not controlled by government rules and regulations. Measured inflation is very close to zero (actually below zero in April 2003), and if one looks at prices that are free to move up and down, Germany is already in deflation. Technically, the U.S. inflation rate is positive—1.2 percent on the GDP deflator during 2002. But much of this inflation is localized in health care. Health care inflation is not caused by the same factors that cause inflation in the rest of the economy. It is driven by new, more expensive technologies for treating chronic diseases among a much larger elderly population. The normal remedies for inflation elsewhere—deliberately raising interest rates to create recessions and reduce demand—does nothing to stop it. Subtract health care inflation, and the inflation rate for the rest of the U.S. economy is 0.3 percent. The United States is not yet into deflation but it is very close.
As average inflation rates near zero, many industries face falling prices long before deflation technically sets in. On the 2002 inflation-deflation teeter-totter, computer prices were down 22 percent, used car prices were down 6 percent, and audio equipment prices were down 5 percent while gasoline prices were going up 26 percent, drugs were up 5 percent, and legal and funeral services were up 4 percent.1 Industries facing persistently falling prices have to take the necessary defensive measures, such as focusing on paying off debts, even if the average rate of inflation is still positive. Relative to the prices at which they sell their products, the real values of their debts are going up. As inflation approaches zero, the number of industries facing the reality of persistently falling prices increases and the negative effects of deflation set in well before deflation technically arrives. That is why capitalistic economies work best with a positive rate of inflation between 2 and 3 percent.
Japan’s deflation was generated by its own peculiar problems—rapidly falling asset prices and a decade of no growth—but deflation has now spread to the rest of East Asia because of wider global realities. The inflation of the 1970s and 1980s did not just suddenly disappear in almost every country in the world because of better management at the world central banks. It disappeared for some very concrete reasons.
It is a basic axiom of economics that in the long run prices follow costs. If costs fall, prices will fall. Initially, those who lead in finding cost reductions make higher profits, but eventually everyone copies their innovations and competition then forces prices down for everyone.
Inflation disappeared because new technologies were lowering costs in many industries such as microelectronics or computers. Think of scanners. They started as very expensive add-ons to computer systems and became an item thrown in free with a new computer purchase. Much cheaper computers and electronic controls widened opportunities for using these technologies in other industries. Much better computers and smarter electronic controls raised productivity and reduced costs in the industries that bought them. With no need for large investments in physical infrastructure, Internet shopping, for example, reduced retailing costs. To get customers to switch, Internet retailers set prices at levels far below those found in conventional stores. This competition in turn forced brick-and-mortar retailers to sharply reduce their prices. As just one example, electronic brokerage firms forced huge reductions in the standard charges for trading stocks and bonds in conventional brokerage firms.
Inflation disappeared because deregulation and privatization reduced costs, increased competition, and forced prices down. Trucking costs, airline fares, and the cost of long distance telephone calls all fell dramatically in the aftermath of deregulation.
Inflation disappeared because global supply chains dramatically reduced the costs of producing labor-intensive goods. If China produces items 30 or 40 percent cheaper than they could be produced in the developed world, prices are going to fall for these products.
Inflation disappeared because of downsizing. Workers were laid off, but those who kept their jobs were also paid less. For the last twenty-five years real wages have been falling at the rate of about a percentage point per year for the bottom 60 percent of the American male workforce. Wage reductions lead to lower costs and in the end to lower prices.
Manufacturing, mining, and construction could easily keep wages down because of the huge reserves of low cost labor they can tap in the service sector. Many of the people now working in the service sector would be delighted to quit their low wage service jobs and move into higher-paying jobs in manufacturing. As a result, even record low unemployment rates in the late 1990s did not lead to inflationary wage increases in manufacturing, mining, and construction.
Name any product, add up the amounts the world could produce if all of the world’s factories were operating at capacity, subtract what the world is going to buy, and you will find that the world’s production potential exceeds the world’s expected consumption by at least one-third in almost every industry. Autos, semiconductor chips, and oil are just three of the many examples. Given normal operations, the world’s auto factories could produce 22 million cars more than the world is going to buy in 2003. Part of this excess capacity comes from new technologies that have dramatically raised productivity. Part of it comes from competitive pressures that force firms to invest in new low cost offshore production capacity even though they were not short of capacity at home. With such an overhang of productive capacity, firms have an enormous incentive to lower prices in an attempt to keep their facilities operating closer to capacity.
Outsourcing reduces prices. It is common practice in America for companies to negotiate contracts that require annual price reductions from their suppliers. Auto parts manufacturers, for example, have signed contracts with the major auto parts suppliers calling for 3 percent annual price reductions. Outsourcing plays a big role in these tough contracts since it is simply easier to get tough on prices with an outside supplier than it is with an inside supplier. If an outside supplier doesn’t make any money with the new lower prices, that is the supplier’s problem. But if an inside supplier doesn’t make any money, what the corporation gains in one of its buying divisions, it loses in one of its selling divisions. There is no gain in aggregate profits. That is why Ford and General Motors spun off their parts manufacturing activities into two new firms. They thought they could get a better deal from Delphi and Visteon if they weren’t part of General Motors and Ford.
Meltdowns such as those in Asia in 1997 substantially increase downward price pressures. Countries such as South Korea have to export more to correct their trade deficits, and with much lower exchange rates they can profitably do so. If their global competitors do not want to lose market shares, they have no choice but to match the Korean price reductions. With a 50 percent decline in the value of its currency, Korean products could be sold for 50 percent less. Japanese export prices had to come down.
Stopping deflation is not easy. In the 1930s a wide variety of approaches were tried, among them instituting minimum selling prices, providing government price supports, and destroying sources of supply—plowing up planted fields before they could be harvested. They all failed.
Once deflation has set in, there is only one cure—a huge sudden fiscal stimulus. In the Great Depression it took the huge fiscal stimulus and change in expectations caused by World War II to do the job. In Japan it will require a large systematic reduction in the value of outstanding debts followed by a big fiscal stimulus. Reducing Japanese debts need not be called bankruptcy, but whatever the process is called, the debts must be reduced. A large part of the fiscal stimulus package might be directed toward writing down all debts by some percentage, say 80 percent. If the prices of positive assets (property and stocks) have fallen by 80 percent, then the value of negative assets has to be reduced by a corresponding amount.
The Japanese often point to their large existing budget deficit and argue that they can do little more. The size of the Japanese government’s current budget deficit is simply irrelevant to the actions that will have to be taken. When the Japanese have blasted their way out of deflation, they can worry about restoring fiscal balance. An accumulation of past mistakes cannot be allowed to foreclose future opportunities to restart the Japanese economy.
Although nothing can be done to change Japan’s past or the fact that East Asia has caught the deflationary disease from Japan, elsewhere prevention has to be the first line of defense. Prevention starts by not letting the inevitable financial crashes of capitalism expand into long-term economic disasters. What to do and what not to do are obvious if we compare the U.S. Savings and Loan crisis and Japan’s Lost Decade.
The GDP data for the 1980s show no signs of the American Savings and Loan crisis. A major financial crash had little or no impact on the system’s aggregate economic performance. Why? In America a czar could be appointed to clean up the mess, the funds necessary to protect bank depositors could be collected from taxpayers, families could walk away from their mortgages when they exceeded the current value of their homes, bankruptcies could be imposed, assets used as collateral could be auctioned off to the highest bidder, and those individuals who crossed the line into illegality could be thrown in jail. The system was sound. It picked up the pieces and smoothly moved on with little or no damage to short-run or long-run economic performance.
Japan could do none of the above. As a result, Japan went from being the industrial world’s best performer in the 1980s to being its worst performer in the 1990s. The system was not sound. Systems that don’t work have to be changed, and the changes don’t happen automatically. Only the Japanese can determine whether the world is going to see the Japan of the 1980s or the Japan of the 1990s in the decade ahead. Solutions demand a change in Japan’s culture, and only Japan can change its own culture.
More important, everyone has to recognize that an inflation prone era in the 1970s and the 1980s ended in the 1990s. Those running central banks have to understand that they have won the war against inflation and are now in a new war against deflation. If they don’t recognize the victory they have had and continue to wage a war against inflation, they are only going to throw their country’s economies into deflation.
Inflation was endemic to the economic system in the 1970s and the 1980s. Faster growth and lower unemployment quickly led to more inflation. But in the 1990s inflation rates fell even as growth accelerated and unemployment reached levels not seen in more than thirty years. The disappearance of inflation in the 1990s marked the fact that something fundamental had changed. If booms produce very low and falling inflation rates, recessions or even slow growth are very likely to produce deflation. And this became the case in 2002. Despite a reasonable recovery in terms of aggregate economic growth rates (2.4 percent) the real wages of American workers fell at all income levels in 2002—at the tenth percentile, at the fiftieth percentile, and at the ninetieth percentile.2 A new deflation prone era has begun. The central dangers are now deflation, not inflation.
Europe should take warning from what is happening in Asia and America and start aggressively stimulating its economies with monetary and fiscal policies to prevent deflation. With downward price pressures flowing from new, more efficient technologies and from new, cheaper global supply chains, letting the second largest economy in the world operate for a long period of time at or near a zero growth rate is a recipe for producing deflation.
To cope with deflation, fiscal policies will have to be reorganized to become part of the solution to recessions and slow recoveries. To make fiscal policies an equal partner with monetary policies in turning recessions around, new procedures are needed. The issue is delay. Getting tax reductions or expenditure increases through Congress simply takes too long. One answer would be to have a congressionally pre-approved package of short-term tax and spending plans triggered by some economic index or by an independent board much like the Federal Reserve Board.3
In the spring of 2003 President Bush did succeed in getting another tax cut through Congress, but once again it focused on long-term tax cuts rather than short-term fiscal stimulus. Whatever one thinks about the double taxation of dividends, cutting long-term dividend taxes in half is not going to stimulate the economy in 2003 or 2004.
Similarly, Europe has to build some flexibility into its stability pact. Rigid fixed limits on fiscal deficits, regardless of the existing economic conditions, don’t make macroeconomic sense.
Much of countercyclical spending should go to preplanned infrastructure projects because they have the great advantage that the extra spending ends when the projects are completed. Infrastructure projects, no matter how big, don’t make long-run deficits larger. Adult education is the other place where spending should rise in recessions. Labor remains idle, and it is a perfect time to retrain the labor force. Firms should be subsidized to put a substantial fraction of their labor hours into retraining—both reducing unemployment and upgrading the labor force. Here again the spending ends when the downturn ends and workers return to employment.
America also needs to reinstitute countercyclical revenue sharing for state and local governments. Vigorous economic recoveries are difficult to engineer if state and local governments are cutting spending and raising taxes by tens of billions of dollars during the initial phases of a recovery.
Since all capitalistic locomotives have built-in stop-go economic engines, having three global locomotives (Japan, Europe, and the United States) rather than one (the United States) would do a lot to reduce global stagnation and deflation. When one engine was stopped, the other two would still be going. Here the problem is not deciding what to do in Europe and Japan but creating in those countries a mind-set that is willing to do what must be done.
The comet hurtling toward the global economy is a “sharply falling dollar.” In the spring of 2003 with the overall (trade-weighted) value of the dollar having fallen 12 percent in the previous twelve months, that comet did not look like science fiction. What should be done about the dangers of a falling dollar is well known.
The American trade deficit should and will eventually disappear, of course. On that issue there is no debate. But a hard landing and a rapid swing from deficit to surplus would be a worldwide disaster. There is one, and only one, route to a soft landing however. Surplus countries have to use monetary and fiscal policies to stimulate their economies to grow faster. If surplus countries adjust, they raise their demands for goods and services and the world economy gets bigger. If the deficit country is forced to adjust, it must reduce its demands for goods and services and the world economy gets smaller. Our only choice is to eliminate the U.S. trade deficit in the context of a rising global GDP or in the context of a falling global GDP.
But recommendations that the surplus countries stimulate their economies have been made many times and are going to be ignored in the countries with the large surpluses just as foreign suggestions to raise savings rates are ignored in America. It is clear that no preventive measures either in America or abroad are going to be taken to prevent a fall in the value of dollar. Americans and foreigners are going to wait for an attack on the dollar to happen—and they will react after they see how much damage is done.
In foreign exchange crises there is a standard IMF remedy: dramatically raise interest rates to discourage capital flight and to encourage capital inflows. Raise taxes, cut spending, and generate budget surpluses to increase local savings, cut consumption, and reduce imports. If applied to America in the midst of a foreign exchange crisis, this formula is a remedy for global economic disaster. An American recession due to high interest rates and fiscal austerity would compound a rest-of-the-world recession caused by the quick disappearance of their trade surpluses.
But it will be politically difficult to argue that America should be treated differently from everyone else. Officially, the IMF will almost have to demand that the United States do what it tells everyone else to do—raise interest rates, raise taxes, and cut spending. Since America does not need the IMF’s dollars to stem the crisis, the IMF will have no power to enforce any of its views on America, but calls for austerity will certainly muddle the situation.
A new model for handling foreign exchange crises will be needed, since this crisis will be very different than those in the post–World War II period. When the dollar does inevitably plunge, the appropriate response is for everyone to immediately adopt highly stimulatory monetary and fiscal policies. The Keynesian pedal will have to be pressed to the metal if the global economy is not to stall and crash. Without such actions, a falling dollar is going to lead to a big downturn in global aggregate demand.
Working out a plan in advance of the crisis has to be better than working out a plan in the midst of a crisis. The IMF and the U.S. government should draw up contingency plans for dealing with the case of a sharply falling dollar. In this case the contingency plans are for an emergency that may, in fact, be fast approaching in the spring of 2003 if one looks at the rate at which the value of the dollar is falling vis-à-vis the Euro.
The long-run health of the global system depends upon an agreed-upon, enforceable global system of intellectual property rights. It is needed and it is to be had. The mantra for the design process is simple: Don’t handicap those who want to develop. Find a way to provide cheap medicines for the sick who are poor. Maintain incentives to make huge investments in new ideas.
To facilitate economic development, the amount of legal copying should be made inversely proportional to a country’s per capita income, going down as per capita incomes go up. The Doha negotiations should set up a fee schedule for using patents that begins at zero for very poor countries, rises as per capita income rises, and then becomes a market-determined system when a country’s per capita income exceeds some level.
To get life-saving drugs to poor people who need them, the right answer is a system much like the eminent domain systems for taking land needed for national infrastructure projects. Rich developed countries simply buy the relevant patents and let everyone freely use them. If the inventing company won’t sell, a court sets the fair selling price. This maintains the incentives for invention while giving low cost drugs to everyone who needs them in rich countries and in poor countries alike.
For those countries that don’t adopt or won’t enforce the agreed-upon system of intellectual property rights, there are simple methods to encourage self-enforcement. The United States simply announces it will keep a country-by-country record of annual sales lost to the infringement of American intellectual property rights. American firms will then be allowed to legally and freely use any patents or copyrights owned by firms based in the offending country. The American firms will continue doing so until the American sales gained by infringing on this foreign country’s intellectual property rights are equal to the sales lost by their infringement of American intellectual property rights.
For countries such as Israel that now fail to obey the rules and already have substantial amounts of their own intellectual property, this formula will encourage quick adherence to the rules of the game. Countries without substantial amounts of intellectual property may continue to violate the rules of the game for a while, but they will know they are storing up enormous future intellectual property right debts for themselves if they do so. They will quickly come into compliance.
Globalization’s impact on inequality depends on how, exactly, inequality is measured—male versus female, top versus middle, middle versus bottom, individuals versus families, or wealth versus income. Nonetheless, antiglobalizers’ predictions that inequality will rise are certainly right if one looks at the income gaps between the well educated and the poorly educated. But the prime cause is not found in globalization. The prime cause of rising inequality is the skill-intensive shift built into the third industrial revolution. Unskilled labor is simply going to be worth less and less. That is dictated by technology.
The right answer to rising wage differentials is shrinking skill differentials. Arguments about the relative size of the roles played by globalization, capitalism, and the knowledge-based economy in generating more income inequality are irrelevant. The solution in all three cases is found in education and skill enhancements. This means an all-out push to ensure that everyone develops a set of marketable skills and the ability to learn new skills over the course of their lifetimes. Sets of skills acquired by age 18 or 22 that can be continuously used over a working lifetime are going to be few. Adult re-education is going to have to become a reality rather than a buzzword—much talked about but seldom seen. Education and training have to be the prime answer to rising inequality. Anything else is equivalent to applying cosmetics rather than antibiotics to a serious wound.
In the United States these better skills need to be coupled with mechanisms for reducing average wage differentials between services and manufacturing so that when workers move into service jobs, they don’t take a big cut in wages and fringe benefits. Millions have moved into services and millions more are going to move to services.
The right starting place is to abolish the laws that allow those who employ part-time workers to avoid paying health care benefits and pensions. These laws make part-timers cheaper, but turnover rates are very high among part-time workers and as a result skill training is almost never given to part-time workers. If firms were forced to pay full fringe benefit packages to part-time workers, they would switch back to what would become cheaper full-time workers. More training would be given, and average wages would undoubtedly rise in the service sector.
Better-targeted and in some countries larger social welfare benefits may also be needed to prevent inequality. Globalization creates no competitive necessity to cut back on social welfare policies or to refrain from expanding them. It does, however, demand that the system be funded with value-added taxes and not payroll taxes. Because value-added taxes are added to imports and subtracted from exports, value-added taxes do not raise or lower the prices of domestically produced goods and services vis-à-vis the prices of internationally produced goods and services. As a result, only value-added taxes do not affect the global competitive equation. Those who are first to replace corporate income taxes and payroll taxes with value-added taxes are going to get an edge. The governments that are last to realize this reality are going to be governing nations that are falling behind.
The feeling that too much of the newly developing global culture comes via the United States is an accurate perception, but the feeling that too much is an export of traditional American culture is wrong. Much of the new global culture is being created in the United States, but far more than half of the ingredients come from other places. This new global culture is changing traditional American culture as fast, or perhaps faster, than anywhere else in the world. The United States is essentially an importer of culture, a modifier of those imported cultures, and then a re-exporter of a new global culture. The goal for others should not be to keep out that American-made global culture but to become more active participants in building their share of this new global culture.
To some extent this is already happening. Part of the success of American-made TV programs was clearly transitory. Most of the world started the TV era with one government-owned and -run television network. The transition to private ownership and multiple networks was marked by a temporary shortage of world programming, and so American programs came to dominate what was watched on these new private channels in many countries. But as these new networks matured and had the time to gradually scale up their own programming, American dominance has all but disappeared. Few American programs are now shown in prime time elsewhere in the world. Local programming has replaced them. The same pattern is apt to happen in movies and in many other cultural areas as well.
Reverse cultural exports are already starting to appear. Americans already watch Taiwanese-U.S. movies (Crouching Tiger, Hidden Dragon) and Hindu-U.S. movies (Monsoon Wedding), and they will soon probably watch foreign movies that do not have an American link.
But the real answer to fears of a cultural invasion is found in self-confidence—the idea that my culture will survive and it is a great culture even if it changes with globalization.
Those who object to global government (either international institutions or an American hegemony) have an unsolvable problem. The global economy requires some global regulation, and no democratically elected national government would either accept the direct election of the leaders of international organizations or give those institutions the power to independently collect taxes from their citizens. As a result, institutions like the United Nations, IMF, WTO, and World Bank are simply needed.
Since international institutions have been set up to cover most international economic problems, unilateral American interventions are almost always generated by political and military events. Iraq is obviously the best current example. With or without globalization, geopolitical, military events such as the conflict with Iraq would occur, and there would be calls for the United States to intervene or not to intervene.
When it comes to using U.S. military power, the rest of the world is clearly ambivalent. Half of the time it asks the United States to intervene, as in Kosovo, Bosnia, and Uganda, and half of the time it asks the United States not to intervene, as in Iraq. Half of the time (Iraq) it wants the United States to work multilaterally through agencies such as the UN Security Council, and half of the time (North Korea) it wants the United States to work alone.
Whereas a lot of attention has focused on U.S. decisions to intervene or not to intervene, little attention has focused on Japan’s and Europe’s refusals to play roles that correspond to their economic wealth and national self-interest. Japan pays little attention to those parts of the world that do not directly affect it. Only China and North Korea get its attention. And even then it is a hand-wringing form of attention rather than attention that leads to actions to avoid or solve problems.
Europe is so focused on building and expanding the European Union that it pays little attention to most of the rest of the world. Put simply, Europe opts out on North Korea, and Japan opts out on Yugoslavia. When the best advice the Europeans can give themselves is to “wait for an American recovery,” as they declared when considering how to get out of the mire of the 2001 recession, the world has a problem, but it isn’t a problem of too much American leadership. It is a problem of too little global leadership from the other two big players, Europe and Japan.
Europe and Japan must be willing to act to solve some of the globe’s geopolitical problems if the United States is not to end up becoming too dominant. This, of course, means being willing to spend money on maintaining their military capabilities. In the end, as Chairman Mao said, “all power comes out of the end of a gun,” even if the guns are never used. In Iraq the inspectors might have been able to disarm Saddam Hussein, but they were let back into Iraq only when there were some guns in the neighborhood.
For those who wish to limit U.S. military, political, or economic power, the answer has to be found in harnessing it in a troika with Europe and Japan. And this can happen only if Europe and Japan pull their weight in the troika. If they aren’t willing to do so, Americans will decide when and where to accept or reject requests to stay out or jump in. That’s just the way it is as long as the United States spends more on defense than the next fourteen countries combined.
Some of the globe’s economic problems, such as intellectual property rights and deflation, can be solved. Many of the globe’s economic problems, however, are dilemmas. Dilemmas are problems for which there are no acceptable solutions. All potential solutions have negative effects that may be as large as those of the original problem to be solved. Socialism, for example, eliminates financial crises, but it is not an acceptable solution because it also eliminates economic growth. But almost all of the globe’s dilemmas can be reduced in scale and scope. Economic instability and inequality are two good examples. Neither can be eliminated, but both can be reduced.