Global Policy Forum

Policies That Spawn Economic Inequality Rather Than Free Trade
Could Bring about an Economic Crisis

Thomas Palley*

Around the world there are growing rumbles about globalization, and these rumbles are not confined to activist anti-globalization movements. In East Asia, the financial crisis of 1997 left a jaundiced sense of globalization, though robust economic recovery has tempered that. Globalization's standing has also been badly damaged in Latin America by the meltdown of the Argentine economy in 2000 and successive financial crises in Brazil in 1999 and 2001. In Europe, new fear about globalization is surfacing in a range of countries. In Poland it has taken the form of concern about foreign capital taking over the Polish banking system, and foreign takeover fears also permeate France and Italy. In France and Germany, working people link globalization with pressures to dismantle the social democratic state.

Among Americans, outsourcing of service-sector jobs has become a top concern, possibly the top concern. Opposition to free trade has crept up the income and social-strata ladder to include educated white-collar workers. This new opposition comes on top of existing resentments among blue-collar workers at the loss of well-paying manufacturing jobs.

These developments have raised concerns about the durability of globalization among its supporters. In April 2005, Martin Wolf of "The Financial Times" gave a lecture titled "Will Globalization Survive?" at Washington's prestigious pro-globalization Institute for International Economics. More recently, Harvard professor Jeffry Frieden published a new book, "Global Capitalism: Its Fall and Rise in the 20th Century," featured at a recent International Monetary Fund book forum. Frieden supports globalization, yet the final section of his book is titled ‘Global Capitalism Troubled," and he ruminates on the possibility that, like the globalization of the 19th century, today's globalization may falter.

Looking back to the history of what some historians call the "first globalization" can be highly instructive. However, one problem is an implicit tendency to identify its end with the beginning of World War I in 1914. This is wrong, and contributes to historical misunderstanding that impedes understanding today's globalization.

The first globalization ended with the Wall Street Crash of 1929 and the ensuing Great Depression. That said, WWI was hugely significant because it permanently transformed political conditions. Consequently, when the economic order collapsed in 1929, the response was profoundly affected by the political conditions created by WWI. In the US, Britain and France, the war created political and social conditions that fostered a turn to social democracy. In Germany, the onerous economic burdens of the 1919 Treaty of Versailles fostered a turn to Nazism.

This history has enormous significance for understanding today's predicament. The first lesson is that politics did not bring down the first globalization, which suggests that politics will not bring down today's globalization. The economic crisis of 1929 brought down the first globalization, suggesting that economic crisis will bring down today's globalization. The second lesson is that whereas political developments preceding 1929 did not cause the crash, they mattered enormously for the international response. That too is critical for today.

Governments substantially recreated the pre-war economic system after World War I. Britain and France held on to their empires, and the 1920s saw a revival of international trade and investment whereby trade exceeded peak pre-1914 levels. Technological innovation flourished in the form of automobiles, airplanes, and consumer durables, and Britain returned to the gold standard in 1926.

However, as with the pre-1914 system, the reconstructed system distributed prosperity extremely unevenly. In the US, wealth and income inequality grew during the "roaring twenties." In Britain, the industrial midlands and north suffered from persistent stagnation because of an overvalued exchange rate. And prosperity simply bypassed Germany. Additionally, there was a popular turn to isolationism in response to the carnage wrought by the war. The system was therefore unpopular, and consequently it had few defenders when the crash came. That lesson holds for the current globalization, which is also unpopular and feared.

The so-called first globalization crashed because of inherent financial fragility. Banking systems lacked modern safety nets such as deposit insurance and lenders of last resort, and the gold standard was also intrinsically fragile because countries could demand payment in gold. Consequently, the system was vulnerable to panics, and the danger increased as financial markets and banking systems grew because the supply of gold, the backing asset, was fixed. Once panic started, it was near impossible to stop. Banking systems collapsed, bankruptcy and deflation set in, and the rest is history.

This history suggests that if today's globalization crashes it will also be because of economic factors, but those factors will differ from the past because the system is different. The New Deal era created a system that remedied earlier financial fragility by restricting private ownership of bullion, and creating deposit insurance and lenders of last resort. It also created a new social democratic mass consumption economy in which income was more broadly shared owing to unionization, minimum wages, and social security provisions. However, a social democratic mass consumption economy is expensive for individual capitalists, giving them an incentive to evade its costs. That has been a driving force behind globalization since 1980, and that is the contradiction in today's system.

Business has a private incentive to escape the system to countries with lower costs. Yet, it still needs mass consumption. The system needs a solid middle class, but is also driven to hollow out that middle class. This contradiction has been papered over by consumer borrowing provided by deregulated financial markets and a 25-year asset price boom. The problem is that such borrowing risks prove unsustainable if incomes are hollowed out, and that could stop the economic merry-go-round. If that stoppage produces an economic crash, globalization may crash, too. Globalization will lack political support, after being a primary cause of a hollowed-out middle class.

The pattern of retreat is difficult to predict. One possibility is a return to a world of tariffs and quotas. A second response may be the emergence of regional trade and investment blocs. A third response that would preserve globalization would be the establishment of new domestic and international rules that support a social democratic mass consumption economy. All three scenarios challenge today's elite's program.

Finally, if the global economy crashes, it will be important to correctly identify the economic causes. The Smoot-Hawley tariff was passed in June 1930. Its economic effects were minor for the US given the pre-existing high tariff structure and the minimal extent of US engagement in trade. Indeed, those effects may even have been beneficial in that spending switched from imports to domestically produced goods. Yet, for 75 years, free traders have sought to blame Smoot-Hawley for the Depression and thereby make a case for free trade. The rooster crows at dawn, but does not cause the sunrise. Smoot-Hawley did not cause the Depression. Likewise, trade stalemate and failure of the Doha trade round will not cause the next economic crisis. However, they may coincide, in which event rest assured that globalization boosters will argue causation.

About the Author: Thomas Palley runs the Economics for Democratic and Open Societies Project, and is the former chief economist of the US-China Economic & Security Review Commission. He is the author of "Plenty of Nothing: The Downsizing of the American Dream and the Case for Structural Keynesianism," Princeton University Press, (1998).

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