Emerging Markets in an Upside Down World E-Book

Jerome Booth

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 687

Veröffentlichungsjahr: 2014

Beschreibung

The world is upside down.  The emerging market countries are more important than many investors realise.  They have been catching up with the West over the past few decades.  Greater market freedom has spread since the end of the Cold War, and with it institutional changes which have further assisted emerging economies in becoming more productive, flexible, and resilient.  The Western financial crisis from 2008 has quickened the pace of the relative rise of emerging markets - their relative economic power, and with it political power, but also their financial power as savers, investors and creditors.

Emerging Markets in an Upside Down World - Challenging Perceptions in Asset Allocation and Investment argues that finance theory has misunderstood risk and that this has led to poor investment decisions; and that emerging markets constitute a good example of why traditional finance theory is faulty. The book accurately describes the complex and changing global environment currently facing the investor and asset allocator. It raises many questions often bypassed because of the use of simplifying assumptions and models. The narrative builds towards a checklist of issues and questions for the asset allocator and investor and then to a discussion of a variety of regulatory and policy issues.

Aimed at institutional and retail investors as well as economics, finance, business and international relations students, Emerging Markets in an Upside Down World covers many complex ideas, but is written to be accessible to the non-expert.

Leseprobe

Contents

Cover

Half Title page

Dedication

Title page

Copyright page

Foreword by Nigel Lawson

Acknowledgements

Introduction

I.1 Upside Down: Perception vs Reality

I.2 The Structure of the Book

Chapter 1: Globalisation and the Current Global Economy

1.1 What is Globalisation?

1.2 Economic History and Globalisation

1.3 Recent Globalisation

Chapter 2: Defining Emerging Markets

2.1 The Great Global Rebalancing

2.2 Investing in Emerging Markets

2.3 Emerging Market Debt in the 20Th Century

2.4 The Growth of Local Currency Debt

2.5 Why Invest in Emerging Markets?

Chapter 3: The 2008 Credit Crunch and Aftermath

3.1 Bank Regulation Failure

3.2 The 2008 Crisis

3.3 Depression Risk

3.4 Global Central Bank Imbalances

Chapter 4: Limitations of Economics and Finance Theory

4.1 Theoretical Thought and Limitations

4.2 Economics, a Vehicle for the Ruling Ideology

4.3 Macroeconomics

4.4 Microeconomic Foundations of Macroeconomics

4.5 Bounded Decisions and Behavioural Finance

Chapter 5: What is Risk?

5.1 Specific and Systematic Risk

5.2 Looking Backwards

5.3 Uncertainty

5.4 Risk and Volatility

5.5 Risk in Emerging Markets

5.6 Rating Agencies

5.7 Capacity, Willingness, Trust

5.8 Sovereign Risk: A Three-Layer Approach

5.9 Prejudice, Risk and Markets

Chapter 6: Core/Periphery Disease

6.1 the Core/Periphery Paradigm

6.2 Beyond Core/Periphery

Chapter 7: The Structure of Investment

7.1 Misaligned Incentives

7.2 Confused Incentives

7.3 Evolutionary Dynamics, Institutional Forms

7.4 Network Theory

7.5 Game Theory

7.6 Investor Structure and Liquidity

7.7 Market Segmentation

7.8 Investor Base Structure Matters

Chapter 8: Asset Allocation

8.1 Asset Classes

8.2 How Asset Allocation Occurs Today

8.3 From Efficiency Frontiers to Revealed Preferences

8.4 Asset Allocation vs Manager Selection; Active vs Passive

8.5 Allocating at Sea

Chapter 9: Thinking Strategically in the Investment Process

9.1 Thinking Strategically

9.2 Scenario Planning

9.3 Global Structural Shifts Ahead?

9.4 Investment Process in Emerging Debt

9.5 Conclusion

Chapter 10: A New Way to Invest

10.1 Sense-Checking Assumptions

10.2 Assessing Liabilities

10.3 Your Constraints

10.4 Consider Changing Your Constraints: Agency Issues

10.5 Building Scenarios

10.6 Understanding Market Structure

10.7 Asset Allocation

10.8 Meta-Allocation: Toolset Choice

10.9 Follow the Skillset

10.10 Portfolio Construction and Monitoring

Chapter 11: Regulation and Policy Lessons

11.1 Regulating Financial Institutions: New and old Lessons

11.2 What to do About Systemic Risk?

11.3 Wish List for Emerging Market Policymakers

11.4 Reserve Management and the International Monetary System

11.5 What Investors Can Expect from HIDC Policymakers

11.6 What Investors Can Expect from Emerging Market Policymakers

Chapter 12: Conclusion

12.1 A Final List…

12.2 … for an Upside Down World

Further Research

Disclaimer

Glossary

Bibliography

Index

Emerging Markets in an Upside Down World

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This edition first published in 2014 by John Wiley & Sons Ltd© 2014 Jerome Booth

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Foreword by Nigel Lawson

Jerome Booth was a key member of the 1999 buyout team that turned the Ashmore group into a highly successful investment manager specialising in emerging markets. Having made his fortune, he has now left Ashmore to devote his time to building up a portfolio of business start-ups, philanthropy (particularly in the area of music, his great love) and writing this admirable book.

The heart of the book is the case he makes for investing much more heavily than is customary at the present time in emerging markets, and is directed in particular – although not exclusively – to the institutional investor. It is, of course, widely recognised nowadays that for the foreseeable future the growth prospects of much of the developing world are very much greater than those of the developed world. At the very least, they still have a great deal of catching up to do; and the combination of globalisation and the change from top-down planned economies to largely market economies is enabling them to do so.

Yet despite this, Booth observes, a typical Western pension fund might have around 5% of its portfolio invested in emerging markets and 95% in developed world markets. In his judgement, the emerging market proportion should be more like 50% than 5%. So why have Western institutional investors, as he sees it, got it so wrong?

There are a number of reasons, but the most important is the assumption that the emerging world is a much riskier place to invest in. Booth’s thesis is that, if anything, the reverse is the case. The disastrous banking meltdown of 2008, following the excessive accumulation of debt of all kinds, sovereign and private alike, within what he likes to call the Highly Indebted Developed Countries, has created a risk of default, inflation (the alternative means of default) and sub-normal growth from which the much less indebted emerging world is largely free. At the very least, in his own words, ‘All countries are risky: the emerging markets are those where this is priced in’. In the HIDC, in his judgement, it is not.

You do not have to share his notably downbeat assessment of the likely economic prospect for the developed world at the present time to be persuaded that the conventional assessment of the relative riskiness of investing in emerging markets, as compared with investing in the Western world, is mistaken.

But although the case for investing in emerging markets is at the heart of this book, there is a great deal more to it than that. It is in fact a rare combination of investment expertise and financial sophistication, informed by a thoughtful analysis of the economic and political context in which investment decisions have to be made. In particular, he offers a good account of the causes of the Western world’s banking disaster, stressing in particular both the nonsenses produced by the combinaton of the rational expectations hypothesis and the efficient markets theory, and the extent to which banking and finance fell victim to the principal/agent problem (where the client or investor, as principal, is dependent on an agent whose interests and incentives may be very different from those of the principal).

Jerome Booth has written an original, challenging, stimulating and largely convincing book.

Acknowledgements

I would like to thank all those who contributed comments on earlier drafts and with whom I have debated the issues contained in the book. In particular I would like to thank my past colleagues at Ashmore, starting with Mark Coombs, from whom I have learnt more about emerging markets and investing than I could fit into several books let alone one, and my other management buyout partners Jules Green, Tony Kane, Milan Markovic, Chris Raeder and the late Will Mosely. I would also particularly like to thank Jan Dehn, who took over from me as Ashmore’s Head of Research and who has given me copious feedback on a number of earlier drafts. I also have benefitted greatly from comments from my ex-colleagues Ousmène Mandeng, Milan Markovic, Tolga Ediz, Cemil Urganci, Kevin Bond, Mark Weiller, Marlon Balroop and Karl Sternberg. I would also like to thank Greg McLeod for the cartoon in Chapter 5. The views in this book are of course my own and do not necessarily reflect the views of Ashmore. I also received detailed comments from Peter Oppenheimer. I am also indebted to my father, Jolyon Booth, for his comments and to Luis Ratinoff for inspiring me many years ago to write a book about money and finance, and for helping round out my education early in my professional career. I am also indebted to my other ex-Inter-American Development Bank friends Michael Jacobs (who, shortly after I had received my economics doctorate, teased me for being too efficient with my education), and Héctor Luisi, both of whom gave me detailed comments on earlier drafts. Likewise I am indebted to fellow emerging market investment guru Liam Halligan. I would also like to thank Adam Swallow for believing in this project, and a number of anonymous academic referees for their valuable comments on an earlier draft. My son Marcus helped me greatly in the preparation of the manuscript, as did Anisha Bansal and Claire Sowry. I would also like to thank all those investors and policymakers I have met over the last twenty years who have stimulated me to write the book. I have had countless people telling me I should write one. Somebody once even apologised to me for not reading it – given the circumstances, I explained that that was quite understandable.

Introduction

‘Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance.’

Kahneman (2011, p. 201)

The world is upside down: the emerging market countries are more important than many investors realise. They have been catching up with the West over the past few decades. Greater market freedom has spread since the end of the Cold War, and with it institutional changes which have further assisted emerging economies in becoming more productive, flexible and resilient. The Western financial crisis which began in 2008 has quickened the pace of the relative rise of emerging markets – their relative economic power, and with it political power, but also their financial power as savers, investors and creditors.

The 2008 crisis also revealed intellectual failures in the way we think about the world: in economics, in finance theory and in the practice of investing. We have known about many of these problems for a while, but the 2008 crisis has exposed them more widely and has given impetus to finding alternatives. This book aims to make a contribution to that search.

The credit crunch and then deleveraging are fundamentally due to excess leverage (borrowing) in developed countries. This excess leverage was built up precisely because risk perceptions were artificially low, in part due to emerging market savings being built up excessively by central banks after the Asian crisis of 1997/8 and then invested in the US, so pushing down the US yield curve. This is the very opposite in the emerging world, where risk perception is higher and leverage did not become anything like as excessive. The deleveraging process can apply only where there is excess leverage, and therefore it is fundamentally a problem of the developed world. Emerging markets suffer from collateral damage because they have economic links with overlevered developed countries, but they don’t suffer from the disease itself, and the problems they do have are easier to solve.

This book describes the new world we live and invest in, with particular reference to the role of emerging markets – the new and coming dominant force in the global economy. It also builds the case for an approach to investing that goes beyond the backward-looking asset allocation and investment methodologies currently widespread.

While this book focuses on investment theory and asset allocation in general, emerging markets constitute a common theme due to their central role in the global economy, their richness as a source of prejudices and anomalies typical of current investment practice, but also given my particular expertise and familiarity with them.

The book touches on four topics: the history of emerging markets (sovereign debt in particular); reasons to invest in emerging markets; how institutional investment and the fund management business works; and how financial markets should be regulated. However, this is one book, not four. I have taken the view that the linkages between these topics are sufficiently important to justify touching on all of them, and I have attempted to take the reader on a broad tour of my ideas before presenting some more prescriptive suggestions. If at times the strands appear to diverge, please bear with me. In the interest of space, I have focused on the less well-trodden ground. Hence I have left out many details of emerging market history and current investment opportunities country by country in favour of the bigger picture. That bigger picture is how millions are hostage to prejudice, the grounding of this prejudice in faulty finance theory, and what we can do about this as investors and policymakers.

I.1 UPSIDE DOWN: PERCEPTION VS REALITY

Today’s maps typically have north at the top and developing countries at the bottom. What if we turn the map upside down? And what if we mark up the central part as shown in Figure I.1? The emerging markets are mostly within the area indicated at the centre, with developed countries at the periphery. As well as having the south at the top, the map is a Peters projection – an area-accurate map. How should we look at the world today?

Figure I.1 The world upside down, with developing countries in the middle. Map source: Strebe

Emerging markets are large. They account for over 85% of human population, the bulk of industrial production, energy consumption and economic growth, and around half of recorded economic activity using purchasing power parity. They are anything but peripheral.

The world is also upside down in that many emerging markets are now safer from some of the worst loss investment scenarios than many developed countries. The countries and investments perceived by many as least risky are often highly risky (in part because the risk is not perceived), and vice versa. This is because the developed world has been borrowing and consuming excessively. Three decades of financial sector deepening has extended leverage (borrowing) to unsustainable levels which will take several more decades to unwind. Many developed countries are facing long periods of work-out and slow growth at best. Not so in the emerging world. Emerging markets are nothing like as heavily leveraged and do not face decades of deleveraging ahead.

Whether we look at a map of the world with north or south at the top seems fairly arbitrary, but is it? Many of us subconsciously associate, rightly or wrongly, the northern developed world with superiority and primacy. This is prejudice – take another look at the map and try to think differently for a moment.

This prejudice is an example of how sometimes we simply don’t think consciously about an issue. Our subconscious chooses for us in what Malcolm Gladwell (2005) has called a blink. This is in many cases a desirable efficiency: it makes sense to use models and shortcuts, including subconscious ones, which we have used successfully in the past. Indeed, much of Gladwell’s book laments the suppression of our subconscious skills through damaging conscious rationalisations, and we shall join him in that complaint at various points in the book. We also rely on more conscious models and views developed by others: if someone else has thought it through, we don’t have to. However, sometimes our gut reactions can mislead us. Sometimes the conventional wisdom can be not merely wrong but dangerous. Sometimes a lot of people can be wrong at the same time.

Finance theory is a relatively new and rapidly expanding area of study which still has serious limitations for guiding the practitioner on how to cope with dynamic situations and structural shifts not previously encountered. Every MBA student should be aware that while finance theory has enabled the growth of financial markets, it has also caused major distortions in the global economy. Macroeconomic factors and more general history outside asset price history are often poorly integrated, belittled, ignored or an afterthought when it comes to investors’ allocation decisions. If something is not measurable it may simply not be factored into decisions,1 leading to risks and lost opportunities for investors, as well as systemic problems for regulators and economies.

Moreover, many institutional investors and investment advisers (and regulators) follow the behaviour of their peers and put up with what they know to be bad theory and asset allocation practices. They have not found better alternative methodologies, and unfortunately the thinking is all too prevalent that, after all, it is not their money. Their own interests, including their reputations and careers, affect investment decisions.

A rapidly changing world needs new investment theory and practices. Emerging economies will increasingly affect developed world financial markets. The savers and investors of tomorrow live and invest in emerging markets. They are younger. Their pension funds are immature and growing fast. Their financial markets, currently puny in comparison to existing GDP, let alone future GDP, will expand much faster than the underlying economies. The investor of today and especially of tomorrow needs macroeconomic, historical, political, behavioural and institutional factors fully incorporated dynamically into their thinking. Nondynamic models which treat emerging markets as an afterthought are increasingly a dead end for investors.

This book is intended primarily for those engaged in financial investment and asset allocation. Their task is much more complex than the academy would have us believe. I suggest some ways of including a wide range of inputs into investing, even if this amounts to no more than posing questions for investors and others to consider. This book is also relevant for those students of finance and economics, international relations and emerging markets, looking for input from an investor (myself) as to where they might concentrate further research. To this end, I have attempted to provide an orientation through what I consider the relevant academic literature, but within the constraints of a book accessible to the general reader. I also hope that policymakers and regulators both in the developed and in the emerging world may also find something of use, particularly in Chapter 11, as they ponder how to make sense of the new upside down world we live in.

I.2 THE STRUCTURE OF THE BOOK

The first eight chapters lay the groundwork for the remainder by discussing the state of the world and the state of existing theory. Some prescription is included here, particularly in Chapters 7 and 8, but the later chapters are more wholly prescriptive and targeted at the practical asset allocator and investor (and policymaker in Chapter 11). In a number of chapters the discussion includes a mixture of history, theory and illustration from emerging markets.

In Chapter 1 some consideration of the history of globalisation leads to the observations that underpinning technological change is largely irreversible, and that political centralisation efforts are under stress. We discuss how globalisation shapes demand. We briefly cover the history of commodification. The changing economic landscape of the 20th century is charted through Bretton Woods to the ideological shift in the 1980s to the period of relative stability in the early 2000s.

The West was not always economically dominant, and I observe in Chapter 2 that the growth of debt markets was part of Europe’s economic success story. Other countries have been catching up over the past few decades, and financial markets are playing an important role in that process. The poorest countries are also catching up, but for them Western defence, foreign and aid policies also need to adapt.

The bulk of Chapter 1, however, is an introduction to, and history of, emerging markets, concentrating mostly on the debt markets, and including a description of the major market and policy developments since 1990. Along the way various crises are discussed but also, briefly: the role of the IMF, the rise of market economies and institutional change, macroeconomic shock treatment, the post-Asian crisis build-up of central bank reserves, some thoughts on fixed exchange rates, and the reduced risk, post-1998, of emerging market-specific financial contagion. This is from the perspective of an investor and macroeconomist in the markets and is not necessarily a consensus view. It should convey, though, some of the dynamism and rapid changes in emerging markets, and give context to policy and investment issues discussed later in the book.

The superbubble leading to the 2008 financial crisis is discussed in Chapter 3, including the US housing bubble, the US Federal Reserve’s post-2008 challenge and strategy, subsequent difficulties in the Eurozone, and the unsustainability of excessively large foreign exchange reserves in the emerging markets.

Chapter 4 reviews the state of current economic and finance theory of relevance for, and as used by, investors. To spend a few thousand words to summarise an entire academic discipline (or two) would be rash. Instead, the chapter is necessarily partial and focused on the theory needed to pursue the arguments of the book later on. The discussion does not attempt to be comprehensive in scope or thorough in detail: I highlight some of the main ideas currently used directly or indirectly by investors and allocators in practice and what their limitations are. A cursory history of economic ideas is presented, from classical economics to Keynes, some comments on laissez-faire, and the microeconomic foundations of macroeconomics. Rational expectations theory and the efficient markets hypothesis are introduced and discussed. Much of finance theory is grounded in microeconomics and several of its limitations are discussed, including the fallacy of composition – that what is true for some may not be for all – and that valid theory either has to have realistic assumptions or be empirically testable, which is a problem for parts of finance theory. This brings us to some of the ideas emanating from behavioural finance research. We leave aside some of the details (such as current conventional approaches to asset allocation, which has its own chapter) to later in the book.

Chapter 5 addresses the issue of risk: a subject that deserves its own chapter, as risk management is central to investment and is so much larger a concept than the extrapolation of past volatility. We discuss how risk is not the same as volatility, how risks are different for different people, and how people’s decisions are bounded and investors can herd. We criticise the theoretical distinction between specific and systematic risk – a criticism which undermines some traditional thinking about asset classes – and the overuse of data extrapolation in assessing risk. We make the distinction between risk and uncertainty.

How to assess emerging market sovereign risk is then discussed. In the process we discuss rating agencies, formal models, capacity versus willingness to pay, and the importance of trust. I define political risk and comment on its importance for investors, and introduce a three-layer approach to assessing sovereign risk, consisting of a ratio layer, a policy layer and a prejudice layer.

Following from our upside-down-map thinking, Chapter 6, which builds on Chapters 4 and 5 in criticising traditional concepts of risk, criticises our core/periphery view of the world. In the traditional dominant investor’s view the core is the developed world, the periphery the emerging world. The core affects the periphery, but too often investors belittle or ignore altogether the effect of the periphery on the core. Challenging this outdated view of the world is necessary to free up our minds, enabling us to see emerging markets and global investing in a new light which better reflects risks and opportunities. In the process we discuss some of the problems facing the developed world which emerging markets do not have. We discuss conditions under which fiscal expansion may be a palliative rather than a cure for slow growth. We also frame the concepts of decoupling, and the spread of a bond above a risk-free rate, as core/periphery ideas. We introduce the idea of a relative theory of risk. Use of GDP weights to allocate investments is also considered.

Chapter 7 argues that the proportions of different types of investors who hold a particular asset or asset class – which I refer to as the structure of an investor base – is an important component of risk. Different investors have different liabilities, beliefs and incentives, and sometimes an overwhelming number of investors who hold an asset may wish to sell at the same time, with very little demand to match their supply at anything but much lower prices, and sometimes none at all. Just as Minsky showed that asset values can collapse, so can liquidity – the amount that an asset trades in a given period. Estimates of future liquidity should not always simply be extrapolated from past liquidity, but take into account the structure of the investor base.

In trying to understand investor behaviour, different notions of what it is to be conservative are identified. Herding and pecuniary and non-pecuniary incentives are discussed. We review some of the limitations of models and approaches which ignore investor base structure and consider some possible future alternative avenues: evolutionary theory, network theory and game theory. With examples from the problem of assessing sovereign risk, I introduce a theory of market segmentation, and highlight three warning signals that a market may be in a bubble, namely: a homogenous investor base, a misperception of risk which may shortly change, and leverage.

Chapter 8 focuses on asset allocation. The purpose of this chapter is to describe and critique existing asset allocation techniques as practised – including the agency problems which drive and constrain many decisions. The definition of asset classes is critiqued further, as is the rise of ‘alternatives’ to traditional asset classes, mental accounting, and home bias. The Yale model is briefly introduced and its limitations are discussed. Asset/liability management is included in the critique: its lack of accuracy and timeliness as well as other theoretical deficiencies. The benefits and limitations of inflation-linked bonds to meet liabilities are discussed, and also how the traditional efficiency frontier analysis fails to incorporate utility curves to model investor preferences. We also discuss the two-stage process of asset class allocation followed by manager selection, and the assumptions which frame the debate between active and passive management.

Building on our ideas about asset allocation, Chapter 9 turns more prescriptive. We discuss how one might try to incorporate strategic thinking with scenario planning – thinking through the consequences of possible different futures – into asset allocation and investment processes. We include an illustration of how one might think about allocating shortly after being alerted to major possible uncertainties, namely some investment rules of thumb post the 2008 financial crisis. We discuss the importance of thinking broadly about the macroeconomic environment as an input into asset allocation and dynamic portfolio management, and illustrate this with the way Ashmore, the firm whose 1998/9 management buyout I participated in, and which I worked for until 2013, manages funds.

Bringing the preceding ideas together to inform an asset allocator or investor is the task of Chapter 10, ambitiously entitled ‘A New Way to Invest’. It takes the form of a list of questions and commentary to enable an investor to manage through periods of structural shift and uncertainty, starting with a questioning of our assumptions. It is an aid to prompt investors and an ongoing work in progress, rather than a finished prescription. I hope it might stimulate more research, but mostly that it may help investors and asset allocators to think about underlying issues and risks perhaps previously bypassed. In any case there is no good substitute for thinking issues through in detail.

Chapter 11 focuses on a variety of policy issues arising from the book’s analysis. Crisis brings the opportunity to redesign regulatory oversight. Some new and old but forgotten general lessons about regulating financial institutions are discussed, and then policy responses to systemic risk. Regulation of banks is discussed, but also of other financial markets and institutions. Pension fund regulation could be introduced to tackle money illusion. Regulation should perhaps be better designed to overcome lack of trust and agency problems, including via non-pecuniary incentives and choice architecture. Regulators should perhaps pay more attention to the structures of investor bases and the misperception of risk. Attempts to map investors by both risk perceptions and liability characteristics may prove useful. My theory of investor segmentation may also be of use as a tool for detecting bubbles.

Issues facing policymakers in emerging markets are then more specifically examined, including the opportunities for emerging market banks to expand internationally, the need to avoid dependence on Western rating agencies, the importance of countering core/periphery thinking, and the benefits of building capital markets starting with bond markets (in part to reduce systemic risks). The need to reform the international monetary system is also discussed, as is the challenge of diversifying and reducing excess emerging market central bank reserves. Then there is a section for investors on what to expect from developed market policymakers, and a final section listing some things to expect from emerging market policymakers.

Finally, Chapter 12 concludes with a brief list, complementary to the one at the end of Chapter 11, of further changes investors might see coming from emerging markets in future, summarising some of the arguments referred to in the body of the book, together with some general predictions from my own reading of current trends. I also include a list of possible future research.

1 See Wolfram (2002) for a similar critique of traditional mathematics and science, which is biased to study only problems which are simple to model with formulae.

Chapter 1

Globalisation and the Current Global Economy

‘Globalisation should not be just about interconnecting the bell jars of the privileged few.’

De Soto (2000, p. 219)

‘The benefits of globalization of trade in goods and services are not controversial among economists. Polls of economists indicate that one of [the] few things on which they agree is that the globalization of international trade, in which markets are opened to flows of foreign goods and services, is desirable. But financial globalization, the opening up to flows of foreign capital, is highly controversial, even among economists…’

Mishkin (2006)

In this chapter we discuss some of the background to attitudes towards money and debt. We explore the historical erosion of despotic power. We aim to understand globalisation, both ancient and modern, identifying the trends most important for current events and policy actions.

1.1 WHAT IS GLOBALISATION?

Globalisation has been through a number of cycles including in the nineteenth century period of free trade.1 The term requires careful use: its range and ambiguity in common parlance can cause misunderstanding.

Globalisation is both a state and a process. It has an economic facet, perhaps best described as the greater interconnectedness of trade and investment as transactions costs and barriers reduce, but also the idea of lack of constraint on markets by government. It is this element that investors are ultimately most interested in. But globalisation also has a technological aspect (not distinct from the economic aspect), notably as represented recently by innovations and speed in modern communications. And it has a cultural facet, as exposed in the spread of common means of entertainment and ideas. It homogenises, and through standardisation commodities, but also creates diversity of choice; complicates and simplifies; brings benefits and conflicts; produces winners and losers.

For emerging markets today, globalisation accelerates convergence to the living standards of developed markets. For some, in a world in which the voices of those with something to lose are louder than those who gain, the term is laced with emotive content, often negative, and while it creates jobs and wealth, globalisation is, for many, associated with job losses and erosion of local values.

Ridley (2010) argues that, among other things, it was trade which propagated innovation technology and civilisation, as do Findlay and O’Rourke (2007). Jane Jacobs in her book Systems of Survival (1992) uses a Platonic dialogue to describe the different logics of politics, which is a zero-sum game, and commerce, a positive-sum game. Nations have historically competed for scarce territory, which, if one gained, another must lose; whereas both parties gain from a trade freely entered into.

If we want to avoid conflicts, commerce has a positive role to play. It is no mere historical coincidence that periods of protectionism and limited international trade often precede wars. The failed logic of isolationism and of fighting over land and other limited resources leads from mercantilism to gunboats, to strategic invasions of third countries, and to empire. Empires fall, however, or at best are managed into relative decline. The human tendency to barter and trade is certainly older than recorded history, and has long been geographically broad in extent. Though this is a generalisation, in the progress of greater economic interconnectedness there are waves, affected by human policy and history, as well as trends, driven by technology. Wars of the ‘hard’ and trade variety, restrictions on economic activity and trade, mass migration and natural disasters have all been disruptive but also sometimes stimulate innovation and new forms of economic activity. In contrast, political stability and incentive structures compatible with innovation have generally nurtured both existing patterns in trade and globalisation.

Braudel (1998) in his history of the ancient Mediterranean world argues that early transhumance (seasonal migration between summer and winter pastures) established a pattern of seasonal trade in the region. The world has clearly seen ebbs and flows in the extent of trade links and civilisations. Toynbee (1946) and others have categorised the rise and fall of civilisations, and with them trade and international links. The story of lack of stability wreaking havoc on economies and trade has repeated itself many times. Globalisation can and does ebb as well as flow. Technology has reversed on occasion as inventions have been forgotten once civilisations collapse. Our European Renaissance is in name a rediscovery. Arguably, however, it takes the destruction of civilisation to reverse technology, and in the modern era, as during periods of stability within earlier civilisations, it has been tenacious and non-reversible.

Technology profoundly impacts globalisation. It can aid economic growth, productivity and, by reducing transport costs, trade. Technology, by changing relative prices, also changes our institutions, as Douglass North (1990) has taught us. For example, technology effects disruptive upheavals in communication from time to time. Neil Postman (1985) has described how the written word, printing and then newspapers changed the pace and nature of interconnectedness. For example, in the 19th century, the telegram helped create the commercial success of newspapers and their news – the interest and novelty of new information from a long distance being of interest primarily, if not solely, because it was new. This ‘news’ content eroded and then eclipsed more considered thought, telescoping cultural knowledge and political debate to focus more heavily on the near present. Thus with the telegram came the modern newspapers, and with them came trivia, including the invention of the crossword puzzle – to test the reader’s knowledge of news trivia.

Subsequently broadcasting has impacted our communication patterns: for example, in the 1850s US presidential candidates would deliver speeches several hours long in public debates, long enough to justify meal breaks. That voters would spend the time to listen to such debates, and that they could comprehend the complex structured paragraphs which were so characteristic, stands in stark contrast to the norm of exchange so typical today.

Have we since ‘dumbed down’, and does the process of globalisation contain a series of dumbing-down episodes? Not entirely: the telegram, newspapers and then radio and television created a breadth of participation in culture not previously experienced. Political debates became less elitist and more inclusive, with more elite communication and interaction continuing, but less dominantly – less unchallenged.

The perception of dumbing down, and indeed the collapse of our sense of history to a more myopic immediate past, is clearly a strong one but not just a 19th-century one. The impact of television is an issue studied by Postman and especially in the post-Second-World-War US context by Robert Putnam (2000). His book Bowling Alone created a vigorous debate about whether television has been the main factor behind the postwar decline of US civic culture (an example of which has been the decline of community bowling alleys). Cries of ‘Dumbing down!’ go all the way back in history. The move from the oral tradition to the written word was lamented in ancient Greece and seen as destructive of the memory skills developed in the time when Homer’s ‘Iliad’ and ‘Odyssey’ – arguably still the greatest epics of literature – were related by word of mouth.2 Broad access to books, particularly the Bible in 16th-century Europe, facilitated religious revolution and war. Dumbing down may look sacrilegious to an elite,3 but while it may represent a destruction of the means of valuable interchange of ideas, at the same time it can be revelatory and intellectually enriching for many more people not previously communicating with each other.

Technological change in the media has been not only traumatic but also irresistible as old technologies have been replaced. It affects the way newer generations think and interact. There is a feeling of erosive unstoppable destruction of the old as globalisation, via new media, invades. New technologies and the young bring myopia and collective amnesia. Older generations and traditional societies alike feel the tension as their children and communities adopt new modes of speech and ways of thinking and abandon the past. And this is not new. We may fear (or embrace) such change but we can’t credibly blame (or give all the credit to) our children. Globalisation may be a more convenient and acceptable receptacle for our emotional discomfort.

Modern communications have massively increased information flow, and the technologies of the Internet and mobile phone have leapfrogged older technologies in many developing countries.4 As with technological change before, much of this is inexorable and non-reversible. Knowledge of the wider world and aspirations for a better life combine in emerging countries to increase awareness. As populations become more vocal, this leads to pressure on elites for political and economic reform at home.

Economic growth and international competitiveness is in part the result of greater entrepreneurial opportunities. Others leave and migrate to the developed world, competing in labour markets there. Either way, the result is greater economic competition with the developed world, which either has to adapt or face job losses from increased competition. Thus many in the developed world feel threatened by globalisation, while at the same time it opens vast new opportunities to many in developing economies.

Part of globalisation is significant international trade, and also substantial cross-border flows of factors of production (capital, labour, technology). These flows take advantage of pricing differences, but in the process, also help reduce them – globalisation helps move the global economy towards an equalisation of returns to factors of production. It also involves multilateral production, and with it the spread of ideas and technology. There is greater openness to foreign inward investment. There is competition between governments for that investment, and for the jobs and knowledge which come attached. Different parts of the same production process may take place in several countries, exploiting comparative advantages. This is made possible by sufficiently low levels of protectionism and reliable low cost transport.

1.2 ECONOMIC HISTORY AND GLOBALISATION

To concentrate on the economic facets of globalisation, it may be useful to consider its historical precedents. Large-scale globalisation is not new. Maddison5 argues that ‘[i]n proportionate terms, globalisation was much more important from 1500 to 1870 than it has been since. A great part … due to gains from increased specialisation and increases in the scale of production’. International trade and capital flows are much larger today, but so is the global economy. There was an interruption as the world went to war in the 20th century, and then protectionism was only reduced gradually, but globalisation is clearly not a novelty.

There are also long economic waves of concern with inflation and deflation. Allen (2005) for example argues that the inflation of the 1970s was partly born from the concern over employment that had previously dominated since the Depression, and similar long waves have been picked by many others since Kondratiev (1925).

Kaplinsky (2005) makes a comparison between the late 19th and early 20th century period of internationalisation on the one hand, and on the other hand the period of globalisation starting in the late 20th century. He comments on the different mix of goods traded, and on the different migration patterns – of the poor in the earlier phase and the skilled and a greater proportion of the monied in the latter.6

He also points out7 that there is a high correlation between effective financial intermediation and economic growth, but that excessive volatility can reduce growth. Hence policymakers often want the competition, ideas and capital which come with openness but are concerned about volatility. Although portfolio investors are not necessarily short term in their outlook, some policymakers – not liking potential volatility in their exchange rate driven by short-term changes in cross-border portfolio flows – are attracted to the idea of discouraging portfolio flows through taxing capital inflows rather than trying to attract more long-term stable investors. Yet trying to prevent inflows rarely has more than a temporary impact on the exchange rate; given inevitable efforts to bypass the restrictions, it can encourage speculative pools of capital and discourage longer-term flows. Hence the simple mantra that characterises portfolio flows as speculative and thus undesirable may be misplaced. Indeed, efforts to restrict such flows can result in more not less volatility.8

1.2.1 The desire to control and its impact on trade

Why do simple policy measures to reduce volatility so often backfire? Today’s environment is one of economic complexity, economic liberty and freedom of thought and action. There is a lot of uncontrolled international movement of goods and capital, whereas in the pre-industrial past the movement that did exist was smaller and simpler. The state may have become less able to impose direct control on the mass of individuals and firms, but many have also become more sophisticated at indirect control and at exploiting the behaviour of firms. As Lucas (1976) pointed out in the so-called ‘Lucas critique’, the use of aggregate macroeconomic data to predict the effect of policy changes can be frustrated. This is due to the behaviour captured by such aggregate data not being independent from policy, but affected in complex ways.

Political control in many spheres has changed. It has been decentralised in some cases as smaller groups have asserted themselves and the centre become less powerful, such as during the fall of Rome in the 4th century, but also due to deliberate delegation of responsibility downwards. In other spheres power has centralised, and many of the problems faced by policymakers today require action above the level of the nation-state to be effective, including some aspects of anti-terrorism and environmental policy. As people’s identities and loyalties have multiplied and become more complex and global, identification with the state has also changed, and the degree to which countries can co-opt their citizens in certain ways.

But democracy and well-being are both probably strengthened by this greater complexity. The multiplication of special interests, competing with each other, reaches a point beyond which any central source of political power can command a majority of support whatever mix of policies is chosen. Democratic institutional forms constitute instead legitimising filter mechanisms, the function of which is not merely to create compromises between political groupings but also to allow all politically active groups and individuals to accept and abide by these compromises. Such decentralisation of power is incompatible with authoritarianism. Authoritarian governments fail when their populations no longer acquiesce to their policies.

Today, the freedom of action which comes from the failure of totalitarianism and central power through filter mechanisms such as democracy, erodes national boundaries and creates more scope for globalisation. Competition of ideas and in markets aids creativeness and wealth production.

Let us cast our minds back to medieval Europe, and in particular England. A useful working hypothesis for any government is that it strives to maximise revenue in order, in turn, to maximise power.9 Medieval monarchs needed revenues for wars, and could often justify taxes to finance them. How they managed this is instructive for how economies, international trade and capital markets developed. A characteristic of England’s history is that the king’s power, being weaker with regard to the aristocracy compared with that of the king of France, had greater need to legitimise taxation. The Magna Carta of 1215 limited King John’s and subsequent monarchs’ powers (weakening under the Tudors and Stuarts in particular), establishing personal and property freedoms and elevating the rule of law above the will of the monarch. Subsequent efforts to raise taxes were notoriously difficult, but this led to an ironic reversal.

‘The relatively weaker bargaining position of English monarchs vis-à-vis their constituents led to concessions that French monarchs did not have to make. However, the Parliament that evolved ultimately enhanced the ability of English monarchs to tax. Parliament provided a forum for conditional cooperation. It engendered quasi-voluntary compliance and reduced transactions costs.’

Levi (1988)

Compared to 18th-century France or Rome under the later Caesars, tax farming in England was not widely employed, but rather the taxes collected by Parliament and later the bonds issued involved lower transaction costs, were more legitimate and more reliable.

The range of taxes to finance the monarchs (and their wars) was varied, but was also driven by and impacted the pattern of trade. Taxes needed to be collectible with minimum transaction costs and maximum legitimacy, and hence moved from general levies (amounts collected across the population) to consumer goods to trade to income. But strategic and mercantilist concerns over trade led to developments in policy too. In the mid-16th century the focus of English trade policy was to generate employment and food after the devastating costs of war on the continent (the English were at war for much of the previous 50 years, with a break in the 1530s). The discouragement of domestic production of luxuries including luxury clothing, seen as unnecessary and sapping of the national economy, led to surges of some of these items as imports, and so eventually the reversal of the original trade policy.10 Then mercantilist and strategic concerns regarding foreign trade started to give way in the later 17th century to the appreciation that ‘projects’ (schemes of domestic investment for home consumption) were important for the country’s overall income and economic health.11 Patents, starting from the Tudors (the first in 1552 for a technique for making glass, then in 1554 to search for and work metals in England), were established to promote production but often led to the aristocratic holders of such exclusive licences closing down domestic (and less aristocratic) competition. International trade was a small share of the total economy, but it was also clearly impacted by the dominant position of government policy in the national economy. We can say there were periods of great increase in foreign trade, but it was still very much monitored and to a large extent controlled or controllable by governments. Governments in turn acted for a combination of political, strategic and revenue-maximising ways, both directly and through taxes, distorting the incentives to trade.

Today’s economic freedoms contrast with more restricted governance structures dominated by guilds and serfdom, tariffs and trade restrictions, economic dependency and personal immobility, and general government heavy-handedness. Whereas the norm in medieval Europe was that companies would seek a licence to engage in certain activities, now companies are prevented from not doing certain things – i.e. they can do anything else. Over time, governments have become less able to ignore the wishes of their citizens. And this is true globally not just nationally.

1.2.2 The influence of money

While our focus is economics, other social forces have also constrained and shaped economic activity. If importation of luxuries was long seen in medieval England as a distraction from more legitimate economic activities, attitudes to money as the medium of exchange take centre stage in the battle between God and Mammon. The history of money is fascinating, as is its sociology and philosophy.12 The association of money with moral impurity is a common thread from Judas Iscariot to the laws against usury and right up to the present day. In Christian Europe at least, financial market development was restricted by religious mores. However, monarchs still needed to fight, and that cost money. The first banks began in the 15th century, and international loans commonly funded wars between monarchs. Potosí silver fuelled the wealth and power of 16th-century Spain, but the lack of development of a domestic capital market led to Spain under Philip II defaulting again and again to foreign bankers. Florence, Genoa and Amsterdam built their economies on international loans as well as international trade.

Banks were originally a place to secure one’s money. Once they started lending out more than they had through issuing notes, there was a risk of bank runs… and the bigger the bank, the bigger the run. Though the Bank of England (1664) and Sveriges Bank (1668) were already established, the mass creation of credit proposed by John Law to the French government, in effect creating a central bank, was initially rejected in 1715, even though the French government was near default following the War of the Spanish Succession (1701–1714) and the Sun King’s defeats at the hands of the Duke of Malborough and Prince Eugene. However, Law was allowed to establish the Banque Général, a private bank allowed to issue bank notes in place of scarce gold and so stimulate the economy. The bank in effect became the central bank, and from there Law’s scope for credit creation grew and grew in an 18th-century version of our modern-day quantitative easing (QE). Initially providing assistance in financing government, by 1717, Law’s notes were legal tender for paying taxes.

The attraction of printing money and credit extension became apparent as a giant means of financing government. Depositors and equity holders came to trust in paper returns. The bank also became an investor in the Mississippi, and shares in the bank were bid up in a financial bubble fuelled by promises of profits which were not forthcoming. It all ended in tears with one of the largest bubble-bursts in history in 1720; but for about 15 months this Scotsman, made Duke of Arkansas but wanted for murder in England,13 was the most powerful man in France. Love of ingenious financial alchemy (the successful stimulus to the French economy by the initial period of credit creation) was followed by hate (the bursting of the Mississippi speculative bubble); just as today international bank alchemy (a key element of modern globalisation) can create huge benefits but then excessive leverage and crises, followed by public opprobrium.

The closeness of bankers to political power continues to the present day.14 The Rothschilds’ agent in 19th-century Berlin, Gerson Bleichröder, became Bismarck’s personal banker but also was central to the finances of the German state and even to foreign policy. Bleichröder provided Bismarck with backchannels via the Rothschilds to the government in Paris and to Disraeli in London. He also was heavily involved in foreign investment, particularly in railways (see Stern, 1977). Likewise in the 20th century, John Pierpont Morgan was famous for playing the role of domestic central bank, stopping the US financial panic of 1907. The associations between finance, international relations and globalisation have long been strong.

1.2.3 Trade and commodification

International trade enables international specialisation. In Britain’s case it was the colonies and the ability to import food and raw materials which enabled the industrial revolution. One needs political stability and trust for international trade and globalisation, and trust is personal and built on reputation – hence the growth of family partnership merchant banks, with their own money on the line. These banks had detailed knowledge about others; but, as they lived or died on their reputation, which could be shattered by a single scandal, they kept secrets well.

Globalisation also entails creating the demand for international trade. Trade has existed for centuries, but large-scale trade had to wait for the consumer society. Prior to this, trade was either in luxuries for the few, or in one or two goods for the many. Roman imports of grain from North Africa were clearly considerable in scale, and a staple for the urban population but the more normal pattern has been of relative self-sufficiency in most staples until the past few centuries, when large-scale trade in grain and textiles resumed. Trade built over several centuries in Europe, but important steps on the way were recognition from the late 17th century of the importance of domestic demand; increasing rural industry and incomes; agricultural enclosure and labour specialisation; and urbanisation.

Commodification – assigning economic value to things not previously so considered – was also a crucial step. London’s Great Exhibition of 1851 was a triumph for the establishment of the commodity at centre stage. The exhibits were not explicitly for sale, but rather there for the glorification of industry and the production of items – commodities from soap to tea to heavy machinery – of use to the consumer and society. This was a revolutionary change and to a large extent the attraction of the exhibition: the focus of the commodity from derivative to dominator of human relations (and not just economic relations). Modern advertising and branding were born, and in some of the pictorial advertisements of the time people were in clearly subservient (smaller and not as important) positions to the commodity.15 Complementary to this radical change was the British Empire, acquired as if by accident for an unknown purpose, but now perceived as having an important role in supplying the growing needs of the consumer (even if the Americas in practice were more important in this role).

If the Great Exhibition drove the desire for domestic consumption, truly dominant mass consumption had to wait for Henry Ford in the US during the early 20th century. Commodification continues to this day and is a distinctive part of globalisation, combined with its offspring, advertising and branding.

1.2.4 Nationalism

Interaction between nations has also changed. Nationalism is a fairly new concept in its modern sense, with nation-states developing in the 1700s, as Hobsbawm (1990) has pointed out. It may yet, as a result of globalisation and the political consequences of societal complexity already mentioned, give way to more multinational political structures. It has already changed greatly. No longer (with a few exceptions) is it an extension of a monarch’s ego: ‘L’état, c’est moi’ as Louis XIV, the Sun King, is supposed to have described it. The peace of Westphalia in 1648 after the devastating Thirty Years’ War between Catholic and Protestant forces defined the sovereign state and established the principle of non-interference in the affairs of other sovereign states. But as Philip Bobbitt (2002) has described, the state has been through several stages of development since. Most recently, as the 1990s Balkan wars demonstrated, the concept of non-interference established in 1648 is now in conflict with that of self-determination. Having said that, global interference has always been with us: stronger states interfering in the affairs of smaller ones for a combination of reasons: their own (individual or collective) security, economic self-interest and humanitarian aid. In all but the short term, however, self-interest of some description invariably dominates.16

What global media and culture have aided is the move to a new reality in which the winning of hearts and minds is central to the modern strategic battleground, and in which traditional armed forces are largely redundant. As a population becomes more educated it will organise and will demand political rights: its voice17 will be heard and authority perceived to be unjust becomes more difficult to preserve. The days when the 1000-strong Indian Civil Service of British expatriate administrators could run a subcontinent of 300 million is long gone, as was predicted since the British enhanced education for Indians from the 1830s. The values the British chose to spread in India were incompatible with their longer-term presence. Today the spread of these and similar values makes similar long-term passive subjugation of nations quite impossible. In today’s world of the Internet and global media, guerrilla not industrial warfare, mass political participation not autocracy, control by physical force alone has become absurdly difficult – even if this is not yet sufficiently understood to have prevented some recent attempts.

Winning minds is the clear preferred route to stable prosperity in today’s world, with a more limited support role reserved for physical force. This is in contrast to much of the structure of defence spending, as discussed by two modern generals with recent experience in the Balkans: Clark (2001) and Smith (2005). What has changed is not merely our education and communications technology, but the number of independent countries18 and also the principle of non-intervention in what were previously considered the internal affairs of nation-states. The principle of such non-interference is now in conflict with the desires, often supported by international opinion, of certain sub-national groups for self-determination. The nation-state has changed its form several times before. As nationalism is a relatively modern phenomenon in many ways, one should expect it to change further.19

Jane Jacobs describes politics as a zero-sum game, but maybe it is even worse: due to fragmentation and more issues requiring international co-operation, states are experiencing shrinking power. Some international problems which would have been resolved by a few countries in the past are now not being resolved. In the wake of globalisation, national politics are becoming less and less autonomous. A number of immigration, environmental and economic issues require supranational governance. In the face of these issues, and in the absence of powerful international institutions, national governments are becoming more impotent; and electorates, realising this, are becoming more frustrated that issues are not being resolved – more apathetic (as shown by voter participation trends), more difficult to please.

Winning minds is about having people agree with you, after letting them freely choose to do so. For the West this freedom or empowerment means allowing people to run their own lives, but also giving up some power – including sharing responsibility with emerging markets. Much more serious reform of the voting shares of the IMF, still heavily dominated by the US and Western Europe, would be a start. The problem is that some Western politicians have great difficulty with implementing this, or giving up their influence, especially when they have little central collective leadership, or are leaders with outdated world views. They often seem oblivious to the observable reality that their policies are getting in the way. Investors, the ultimate pragmatists, have the potential to offset the zero-sum (or all too often negative-sum) logic of politics. Commerce is an important component in bridging conflicts and avoiding them, of getting over ideological prejudices, of creating mutually aligned incentives: in short, of keeping down the testosterone levels in politics.