Stephen King: Europe faces an uncertain future as globalisation takes hold

Yes, it's the beginning of 2004 and you're probably expecting me to make some predictions for the year ahead. Sorry to disappoint you but I've chosen not to. Why? Partly because predictions are less interesting than risks. Economists are very happy to make boring predictions all too frequently, deviating by only a tiny amount from the consensus - but often choose not to think about the risks that really might upset the applecart. I'll talk about some of these key risks in more detail next week. Mainly, though, I'm going to avoid predictions for the year ahead because I received a time machine at Christmas, which enabled me to write a provisional economic history of the first decade of the new millennium.

So, fast forward to 2010. I am just about to submit my manuscript to the publishers, highlighting the major economic successes and failures over the past 10 years. The publishers have asked me to provide a short summary. So, here goes.

At the top of my list is globalisation. Although many economists a decade ago decided to treat globalisation as an insignificant irritant, something that they could not easily quantify in their clever mathematical models, it turns out that globalisation was the single most important driving force in the world economy in the first decade of the new millennium. It changed the ways in which we all thought about economic events and reduced policy makers to "bit-part" players on the world economic stage.

Why was globalisation so important? For starters, it was a force unleashed across borders, something that could not easily be regulated or controlled by national governments or central banks. The old distinctions between capitalism and communism became, for the most part, irrelevant and global debate moved on to the case for economic versus spiritual satisfaction. Often the debate was entirely benign but, on some occasions, there was a nasty backlash, most tragically in the form of terrorist atrocities.

But there was little that anyone could do about globalisation. It was an inevitable process. Technologies had led to a collapse in communication costs around the world, joining together communities that had previously been completely separate from one another. Capital mobility meant that companies could set up shop wherever labour costs were at their most competitive, leading to a mass capital migration out of Europe and, to a lesser extent, the United States. Labour migration promised to delay the inevitable ageing population problems that had so vexed policy makers, notably within Western Europe.

Those that resisted globalisation were a motley crew. Some were against it because they believed that multinationals were essentially evil. They formed part of the global anti-capitalist movement. Others were against it because they wanted to protect domestic jobs in the western world, even though this left workers in other parts of the world without decent jobs, without decent incomes and without decent opportunities. Still others opposed the inevitable march towards a single global economy because they were racist, nationalist or against religious diversity. They resisted the mass immigration of labour that was fast becoming an inevitable feature of globalisation.

But they could not win. Their only chance of victory lay in the short-term aspirations of myopic policy makers, those that sought to throw a spanner in the works of better resource allocation. These were the protectionists, people who wanted to defend jobs in industry, in agriculture and in services that were now threatened - at least in the western world - by the newly "joined-up" global labour and capital markets. Yet this was ultimately a self-defeating approach: as protectionist policies were adopted, so it became increasingly obvious that politicians were no more than shooting themselves in the foot. Consumers cut off from the cheapest goods and services in any particular market simply took advantage of electronic wizardry to source their purchases from other parts of the world. In an economic sense, national borders began to collapse.

Faced with this newly "joined-up" world, policy makers found themselves slowly running out of ideas. What were their options? From time to time, voters demanded higher public spending, but governments were unwilling to fund these aspirations through higher taxes for fear of triggering a capital exodus. Public choice became increasingly limited: governments resorted to stealth taxes, to only half-hearted promises on public services and to short-termist vote-winning strategies, based more on protectionism than on creative and sensible harnessing of globalised industrial opportunities. Countries either increasingly blamed each other for the "adjustment pains" associated with globalisation, or banded together to form large, sometimes diverse, federal groupings.

Central banks were equally at a loss. As capital flew around the world at ever-increasing speed, countries would find themselves with massive balance of payments surpluses and deficits. This left central banks facing significant dilemmas. Should they assume that capital could flow into a country and stay there for the long-term, in which case, heavy domestic borrowing really wouldn't be a major problem? Or should they, instead, treat capital inflows with suspicion, arguing that the associated domestic borrowing binge would only end in tears?

Underneath all of this, central banks began to grapple with a new problem. Inflation had remained persistently low in the first 10 years of the new millennium and, in effect, had become useless as an indicator of economic stability. Capital flows, asset prices and debt had become the new macroeconomic challenges, yet central banks didn't really know what to do about them. After all, weren't they just a manifestation of the free flow of capital around the world?

True, but policy makers increasingly recognised that unfettered capital flows were in danger of becoming a major new source of instability. The equity bubble that had burst at the beginning of the new millennium was followed by a series of other bubbles - in housing, in commodities - as policy makers fed the illusion that economies could continue to expand no matter how high the level of private sector debt. But by encouraging further capital inflows, policy makers were simply making the eventual denouement that much worse.

As economies lurched from boom to bust and back again, increasingly policy makers called for capital controls. Some of these operated across borders, preventing short-term capital from overly-inflating asset prices in individual countries, notably in the emerging markets. Others operated within borders in the UK, deposit requirements on house purchases were tightened up significantly as the advent of 100 per cent plus mortgages began to destabilise the credit-worthiness of many UK homeowners.

And the winners from this short piece of economic history? At the time of writing - in 2010 - a number of clear themes were beginning to emerge. Those countries that had a labour-cost advantage (see table for Indian example) and which were suspicious of excessive capital inflows performed remarkably well - China fulfilled its promise, India demonstrated galloping, but sustainable, growth, and Brazil was flashing large on the radar screen.

Those that recognised their role in the global economy and were able to switch away from industries where comparative advantage was being eroded away to those which were at the forefront of the new intellectual technologies were able to do well too. The US, with its flexible labour markets, showed promise but its refusal to play the global multilateral trade game and its desire to find foreign scapegoats for its domestic economic adjustment difficulties sadly triggered a series of disruptive protectionist trade wars.

The real loser, though, was Europe: attempting to protect its wealth, suspicious of immigration, unwilling to take risks, it looked upon the new globalised economy with unease. As other parts of the world expanded rapidly, Europe found itself falling further and further behind in the global growth league table: countries like Germany and France that had once stood proudly at the top of the growth league found themselves, alongside the UK, increasingly regarded as economic minnows. The G7 was disbanded and a new "Wealth of Nations" emerged: the US, China and India became the new G3.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com