Reassessing Globalization: Has Faith in Free Markets Led to its Undoing?

Did too much faith in free markets undo globalization?

That’s the question at the center of a new white paper by Stewart Paterson, a Research Fellow at the Hinrich Foundation, who offers a thought-provoking exploration of the forces that are upending global trade dynamics. In a talk with the Association of Foreign Press Correspondents (AFPC-USA), Paterson delved into critical questions that challenge traditional trade theories. By examining the impact of China's state-led capitalism and the resurgence of mercantilism, he provides valuable insights into the changing dynamics of the global economy.

Stewart Paterson

Paterson spent 25 years in capital markets as an equity researcher, strategist and fund manager. He has worked in London, Mumbai, Hong Kong and Singapore in senior roles with Credit Suisse, Credit Suisse First Boston, CLSA and more recently, as a Partner and Portfolio Manager of Tiburon Partners LLP. Having started his career with Hill Samuel in London in 1991, he has covered the full spectrum of global markets equity strategy, developed market equities and emerging market equities, and has seen firsthand the economic impact of China’s integration into the global financial system. In 2007, he co-founded Riley Paterson Investment Management in Singapore, where he ran a macro-driven hedge fund that exploited the anomalies in capital markets being created by globalization and the existing monetary order.

This educational program was held on Monday, October 31 and was moderated by  journalist Patrícia Vasconcellos, the U.S. correspondent for the Brazilian television network SBT. It provided an illuminating journey into the complexities of today's global trade environment, offering a fresh perspective on the future of international commerce.

The AFPC-USA is solely responsible for the content of this educational program. Below, readers will find a summary of some of the most important takeaways from the presentation.

ON HIS WHITE PAPER

• Paterson says the paper is the third in a series of pieces looking at the issues with globalization and how to revive it in “a sustainable way.” He notes that the first of these emphasizes “the uniqueness of the period of the late 20th and early 21st centuries from a holistic point of view because that period of globalization took place against a backdrop of four different factors” he characterizes as “abnormal.”

• There is a single global hegemon—the U.S.—”that was prepared to oversee a multilateral system, support a multilateral system, and give up a lot of the negotiating power that naturally accrues to an economy of its dominance in bilateral relationships.” There was no great power rivalry in the first decade of the 21st century, he adds, which meant “the international dimension to economics, trade and overseas investment… took place in a geopolitical vacuum” according to observers at the time. Trade had also not been “politicized” and there was no “attempt to conflate trade deals or trade negotiations with extraneous factors such as environmental agendas or human rights agendas.” These factors drove globalization forward, and the final factor was a “neoliberal economic philosophy” and a faith in free markets to produce “better solutions than governments could hope to engineer.”

• All of these factors contributed to what is known as the Washington consensus, says Paterson, though he cautions that “the consensus and neoliberalism should not be confused as being synonymous.” The consensus contributed to “undoing” globalization because it was perceived as a common-sense approach that everyone would follow and they did not. China’s own policies—anything but liberal—also hurt globalization, as did market mechanisms that failed to materialize did not lead to “some sort of equity and justice.”

• On China, Paterson says the country harnessed “some of the incentive structures of a market economy, but it was never trying to emulate the economic structure of market economy.” China’s actions are done in accordance with “state wishes.” The rest of the world “underestimated the ability of a planned economy to actually change the market economy and to disrupt markets.”

• Paterson’s white paper observes that trade patterns show no pattern toward equilibrium, tracked over the last “40 to 50 years.” It also explores whether there is “any tendency for currencies to trend towards purchasing parity.” He says: “If there was a tendency for the two to converge that would show that over time there's a tendency for exchange rates to move towards purchasing power parity.” 

• As of now, the gap between the two is as large as it was in 1990, meaning that there has been no “adjustment mechanism” through real effective exchange rate movements. Moreover, “there has been no tendency towards balance of payments equilibrium as “China has run a trade surplus every year since 1993 and those trade surpluses are growing again relative to GDP.” In short, faith in an “adjustment mechanism” was “ill-founded.” Where countries fix their exchange rates, the adjustment mechanism “cannot work in the short run.” This is because “inflation differentials adjust the real exchange rate in order to produce equilibrium outcomes.” 

• China's large current account surpluses led to significant monetary growth, but this did not result in the expected rise in prices due to changes in the velocity of money. The fixed exchange rate environment failed to bring equilibrium to external accounts. Paterson posits that the Chinese economic model's idiosyncrasies raise questions about its compatibility with a sustainable global trading system. The paper concludes that the global trading system is fragile and in need of rectification. The next part of the series will explore potential options for preserving a multilateral trading system.

ON THE FACTORS THAT FACILITATED GLOBALIZATION IN THE PAST

• Paterson explains that during the period when trade and foreign direct investment (FDI) increased significantly, there was a “conscious effort” to separate political factors from trade agreements.

• In his view, the World Trade Organization (WTO) also focused on its principles rather than extraneous political agendas. However, in recent years, human rights and environmental concerns have gained prominence, with consumers and governments showing interest in ethical and environmentally friendly products. 

• At the moment, the European Union is working on a carbon border adjustment mechanism, which, while aimed at being compliant with WTO principles, may face testing in this regard. This shift toward ethical and environmental considerations is expected to introduce complexity, trade friction, accusations of protectionism, and potential fragmentation in the global trading system, in contrast to the absence of such factors in the past, which facilitated globalization.

ON THE IMPACT OF TOPICS LIKE HUMAN RIGHTS, ENVIRONMENTAL CONCERNS, AND CHINA’S RISE ON TRADE

• Paterson observes that China's trading success has been driven by substantial state promotion efforts, and the asymmetric market access has contributed to global trade system inequity. This raises questions about whether the existing rules were insufficient or if China's trading partners should have held them accountable within the World Trade Organization (WTO) framework.

• The WTO operates on trust and “the rise of China has led to a breakdown of that trust.” Remedies have been “slow-coming and arguably insufficient to have modified China's behavior because China is not moving to meet the free trade norm.”

• This situation raises concerns about the effectiveness of multilateralism, suggesting that a more selective approach might be necessary, as seen in the proliferation of bilateral and plurilateral agreements. For example, the EU has become more insular due to the development of a single market, and the United States primarily trades with Mexico and Canada under NAFTA. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) represents a potentially more inclusive multilateral forum for trade deregulation.

ON WHETHER WE SHOULD CONSIDER MAKING CHANGES DUE TO CHINA’S NONCOMPLIANCE AND BECAUSE TRUST IN MULTILATERALISM HAS DECREASED

• The issue, as Paterson sees it, is that :we are arriving at the conclusion that it is really the participation of one large economy in the global trading system that has led” to the breakdown of the multilateral system.  He asks: “Is the way to preserve the vast majority of the benefits of trade to exclude that country from the World Trade Organization. 

• He suggests that if that can't be done, alternative forums might emerge, such as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). This would involve countries interested in deepening market-oriented trade relationships and following best practices. The option of excluding or diminishing China's role in the WTO shouldn't be dismissed, and it could lead to changes in the WTO itself or the rise of more significant alternative forums.

ON CHINA’S INCREASED IMPORTANCE IN QUESTIONING THE NEOLIBERAL MODEL FOR SUSTAINABLE DEVELOPMENT

• Paterson notes that China's success has raised these questions because China significantly improved its per capita GDP over the last 30-40 years. However, China's development model is considered “broken,” moving through two phases: an export-oriented period and a domestic investment-led model. 

• The diminishing returns on capital and overinvestment in China's current model suggest it has run its course. While there's hope that China might adopt a more liberal economic model compatible with external relations, current leadership does not indicate such a direction.

ON CHINA’S “OBSESSION” WITH BUILDING FOREIGN EXCHANGE RESERVES

• Paterson explains that when a country runs a current account surplus, it must export capital, as a result of the trade related net buying of its currency. Historically, China used to buy foreign exchange reserves when it ran a current account surplus. More recently, especially with the Belt and Road Initiative (BRI), the excess capital has been recycled out of China through various state-controlled institutions, including development banks and state-owned commercial banks. Instead of just holding foreign exchange reserves or buying U.S. treasuries, China has diversified into other assets.

• The key difference lies in the ownership of these assets. In China's case, the vast majority of these assets are owned by state-controlled entities. This distinguishes China's internationalization of its balance sheet from other major economies. 

• Additionally, Western countries like the U.S. and the U.K. typically run current account deficits, meaning they must import savings from other countries. When Western countries provide overseas aid, they have to fund it by selling domestic assets in addition to funding the current account deficit, resulting in a different financial situation compared to China.

ON COPYING OTHER MECHANISMS LIKE THE UNITED STATES REGARDING CHINA

• In the context of great power competition and concerns about supply chain resilience and economic coercion from China, governments are inclined to prioritize making goods themselves to improve resilience. However, there is a question: Is there another way? 

• Paterson says an alternative to full self-sufficiency is diversification of supply chains. This diversification relies on trust among trading partners. Geopolitical blocs are already shaping trade relationships in significant ways.

• The solution to ensuring supply chain resilience and security, says Paterson, is not only self-sufficiency but also diversification and trust among trading partners. Industrial policies will play a role, but a more straightforward approach could be to ensure a greater diversity of supply options. For example, if one country dominates global trade in a specific commodity, measures could be implemented to penalize such exports, encouraging the growth of market share for the second or third most efficient producers. This approach reduces the world's dependence on a single producer for essential products.

ON HIS “BIGGEST CONCERN ON A GLOBAL SCALE” AND HIS HOPES FOR THE FUTURE OF GLOBALIZATION

• Paterson's biggest concern is the world's heavy dependence on China for manufacturing and the substantial cost involved in diversifying supply chains to reduce this reliance. 

• He is worried that efforts to secure the world from potential economic coercion will result in a significant loss of economic welfare. 

• His hope is that China can transform into a responsible player in the global community, but he believes this will necessitate a change in leadership. Currently, there is little evidence to suggest that such a change is imminent. 

• His greatest hope is that China, as a major global player, will be led responsibly and in compliance with global norms, which would make the world wealthier and healthier. This hope is balanced by his concern about the current state of affairs.

ON EUROPE’S APPROACH TO GLOBALIZATION AND ITS RELATIONSHIP WITH CHINA

• Paterson highlights the challenge of striking a balance between European and Chinese values, trade dependencies, and the perceived prosperity brought by trade with China.

• He mentions that Germany is the only significant European country that has maintained a reasonably balanced trade relationship with China, although even that has faced challenges such as intellectual property theft and disappointing results in certain industries, particularly in the automotive sector as the world shifts toward electric vehicles. 

• He goes on to suggest that while Europe may not want to appear simply following a U.S.-led stance on China, they are increasingly realizing that US and European interests in economic engagement with China are closely aligned.

ON WHETHER U.S. TRADE POLICY WILL SHIFT TO EXTERNAL STAKEHOLDERS SUCH AS CHINA IN THE EVENT OF A “POLITICAL CHANGE” IN THE U.S.

Hinrich Foundation

• Paterson mentions that during Donald Trump's presidency, there was a perception that his trade policies were a product of his administration, but as President Joe Biden's term progresses, the pushback against China remains strong and has even intensified with export controls.

• He says that the United States' appetite for free trade has diminished due to negative experiences with China, and while the world needs U.S. leadership in trade, a significant shift may not be expected with a change in leadership. He acknowledges that this view is not very strong and open to discussion. He says his view “is based on what we saw during the last transition.”

ON THE PROSPECT OF A CHANGE IN CHINA’S LEADERSHIP AND TRADE POLICY

• Patterson goes on to acknowledge that changes in totalitarian regimes often appear unlikely until they happen, emphasizing that leadership changes might not necessarily entail a collapse of Chinese Communist Party (CCP) rule but could involve different leaders within the party.

• He points out the economic challenges facing China, including underreported youth unemployment and capital flight, which are indicative of economic weakness.

• Paterson suggests that pressure on the current leadership, led by Xi Jinping, could lead to a change in direction, but it depends on the extent of pressure exerted by those within the Communist Party not in power. However, Xi Jinping has been successful in quashing internal opposition so far.

ON THE IMPACT OF ONGOING CONFLICTS IN UKRAINE AND ISRAEL ON GLOBAL TRADE AND GLOBALIZATION

• Paterson emphasizes that the war between Russia and Ukraine has significant economic ramifications because both nations were major commodity suppliers to the global market. This war induced fuel shortages and underscored the dangers of relying on a single source for crucial resources. He says: “It's just a stark reality of the economic structure of the belligerence.”

• He also mentions China's collaboration with Russia and the potential negative implications for global trade and trust between nations.

• The effectiveness of economic sanctions is a complex issue, acknowledges Paterson. He notes that sanctions can be effective if they are designed to achieve a limited goal within a relatively short time frame. However, setting too ambitious targets for sanctions can reduce the chances of success.

• He stresses that while sanctions may not make it impossible for Russia to continue its war, they do constrain Russia's economic progress and its ability to prosecute the war, which can still be considered a form of success, depending on one's definition of success.

ON THE USE OF LOCAL CURRENCIES OR NEW CURRENCIES FOR TRADE

• Vasconcellos brings up the idea of countries like Brazil and India proposing to use local currencies or create a new currency for trade, moving away from the U.S. dollar. Paterson says that this idea is far from reality due to several reasons: 

• First, the US dollar is widely used for trade because it offers a deep and liquid market, which provides clean and quick pricing. Second, financing costs are crucial in trade, and replacing the dollar could raise costs. Furthermore, the distinction between the currency used in trade and external liabilities in dollars can be challenging, as many countries have debt denominated in dollars and need to earn dollars to service that debt.

• Paterson stresses the importance of “a very strong nexus” between a currency's status as a global reserve currency and its use in trade. He also questions whether countries would want to hold foreign exchange reserves in a currency with capital controls and highlight the importance of transparency, information access, and credit ratings in the choice of a reserve currency.

• He goes on to mention that the U.S. dollar has been a strong store of purchasing power compared to many other fiat currencies since the end of the gold standard, making it difficult to argue against its use. He observes that countries criticizing the dollar's status have seen their own currencies depreciate significantly over the years.