Globalization Has Role in This Double Whammy

On the face of it, there's not much to link the London riots and the latest gyrations in global markets. The wave of violence and looting that has spread across the U.K. over the past few days has been mass criminality not a protest movement. And the global stock market rout was triggered by concerns over the euro zone, U.S. government debt and the global recovery rather than anything specific to the U.K. Indeed, the markets have singled out the U.K. as a haven, its debt now cheaper to insure than that of Germany.

Even so, there's a link between the two phenomena – and it is an unsettling one. Both reflect the challenges of globalization. The creation of a rules-based multi-lateral trading system has been one of the greatest triumphs of the past 65 years. But the crash and the riots are evidence of the pressure this system is coming under from above and below.

After the Second World War, victors and vanquished pledged to agree new arrangements to ensure they would never again pursue the destructively nationalistic policies of the 1930s. To prevent a repeat of the trade wars unleashed by the U.S. Smoot Hawley Act of 1930, they signed up to the General Agreement on Tariffs and Trade, which has since evolved into the World Trade Organization. Continental European countries, scarred by memories of tit-for-tat pre-war devaluations, went one step further, creating what became the European Union, now complete with its own currency.

Globalization has been astonishingly successful, both in terms of fostering prosperity and promoting peace. Global leaders have become accustomed to resolving differences through negotiation. The relative stability created a more predictable environment for business to invest and grow, while lower trade barriers allowed companies to compete and become more efficient. The result has been the greatest advance in living standards in history, a process that has accelerated in the past 20 years as former communist countries and other emerging markets joined the global market.

But globalization has always had its dark side, too. This is reflected in the vast global imbalances that have accumulated over several decades. A global market-based system based on the consent of individual national governments can never be perfect. The inevitable compromises mean there will always be winners and losers.

The most glaring imbalances are the giant trade surpluses run by countries such as China, Germany and some other Asian countries and the corresponding deficits run by the U.S., U.K. and some peripheral euro-zone countries. The recycling of currency reserves by surplus countries drove down borrowing costs in deficit countries during the boom, leading to the massive accumulation of debt and asset bubbles. It is the pricking of these bubbles that is causing the current market crisis, exacerbated by the inability of many deficit countries to devalue relative to major creditors because of fixed exchange rates and currency pegs.

Another major imbalance has been the creation of vast social inequalities within countries even as globalization has helped reduce inequalities between countries. Those with capital or rare skills have reaped vast rewards while those forced to sell their labor in a competitive global market have seen their living standards fall or been priced out of the market altogether, whether by workers in foreign countries or immigrants.

During the boom, governments responded to these inequalities by heaping taxes on the stagnating incomes of the middle classes to pay for generous welfare systems for the rapidly emerging underclass excluded from the global economy. "The middle classes only tolerated this," Albert Edwards of Societe Generale notes, "because central bankers created housing booms to keep the impoverished middle classes borrowing and spending to give them the illusion of prosperity and stop them from revolting."

But the middle classes are now being crushed by those debts and fear losing their jobs. Their willingness and ability to pay the welfare bills has been exhausted. At the same time, the economic slowdown has reduced opportunities for the underclass to supplement their benefits in the shadow economy. Even if the current U.K. riots have no overt political motive, it is facile to deny there is a socio-economic dimension to the riots; few Londoners are entirely surprised by events of the past few days.

But if the origins of these crises are global, their solutions must be global too. Currency reform is clearly essential; in particular, China needs to allow the Yuan to float, providing some relief to the U.S. economy. Surplus countries must also find ways to reduce high savings rates and encourage spending, including introducing their own welfare systems. Above all, emerging markets must dismantle barriers to investment so capital can find its way into productive assets rather than driving down yields in financial assets.

But progress on these fronts looks as far away as ever. A year after the G20 committed to address the problem, it has yet to agree even how to measure imbalances let alone tackle them. Besides, surplus countries have their own political constraints: it is fanciful to think China, seeing the London riots and with 800 million people still living in poverty, would willingly adopt a currency reform that might fuel its own social unrest. And Germany doesn't want to saddle its taxpayers with the likely high bill of bailing out the euro zone.

Yet the G20 must act – and fast. The U.K. riots and stock market crash are a warning that global imbalances can't be ignored much longer. Rising social and economic pressures will fuel demands for political action. Despite the global financial crisis, the most important post-war achievements remain intact. Trade is the dog that has not barked. But protectionist pressures, never far below the surface in the boom years, are rising. A return to the beggar-thy-neighbor nationalist politics of the 1930s would truly be a disaster.