Global Policy Forum

Sinking Globalization


By Niall Ferguson*

Foreign Affairs
March/April 2005

Summary: Could globalization collapse? It may seem unlikely today. Yet despite many warnings, people were shocked the last time globalization crumbled, with the onslaught of World War I. Like today, that period was marked by imperial overstretch, great-power rivalry, unstable alliances, rogue regimes, and terrorist organizations. And the world is no better prepared for calamity now.


Ninety years ago this May, the German submarine U-20 sank the Cunard liner Lusitania off the southern coast of Ireland. Nearly 1,200 people, including 128 Americans, lost their lives. Usually remembered for the damage it did to the image of imperial Germany in the United States, the sinking of the Lusitania also symbolized the end of the first age of globalization.

From around 1870 until World War I, the world economy thrived in ways that look familiar today. The mobility of commodities, capital, and labor reached record levels; the sea-lanes and telegraphs across the Atlantic had never been busier, as capital and migrants traveled west and raw materials and manufactures traveled east. In relation to output, exports of both merchandise and capital reached volumes not seen again until the 1980s. Total emigration from Europe between 1880 and 1910 was in excess of 25 million. People spoke euphorically of "the annihilation of distance."

Then, between 1914 and 1918, a horrendous war stopped all of this, sinking globalization. Nearly 13 million tons of shipping were sent to the bottom of the ocean by German submarine attacks. International trade, investment, and migration all collapsed. Moreover, the attempt to resuscitate the world economy after the war's end failed. The global economy effectively disintegrated with the onset of the Great Depression and, after that, with an even bigger world war, in which astonishingly high proportions of production went toward perpetrating destruction.

It may seem excessively pessimistic to worry that this scenario could somehow repeat itself--that our age of globalization could collapse just as our grandparents' did. But it is worth bearing in mind that, despite numerous warnings issued in the early twentieth century about the catastrophic consequences of a war among the European great powers, many people--not least investors, a generally well-informed class--were taken completely by surprise by the outbreak of World War I. The possibility is as real today as it was in 1915 that globalization, like the Lusitania, could be sunk.

Back to the Future

The last age of globalization resembled the current one in numerous ways. It was characterized by relatively free trade, limited restrictions on migration, and hardly any regulation of capital flows. Inflation was low. A wave of technological innovation was revolutionizing the communications and energy sectors; the world first discovered the joys of the telephone, the radio, the internal combustion engine, and paved roads. The U.S. economy was the biggest in the world, and the development of its massive internal market had become the principal source of business innovation. China was opening up, raising all kinds of expectations in the West, and Russia was growing rapidly.

World War I wrecked all of this. Global markets were disrupted and disconnected, first by economic warfare, then by postwar protectionism. Prices went haywire: a number of major economies (Germany's among them) suffered from both hyperinflation and steep deflation in the space of a decade. The technological advances of the 1900s petered out: innovation hit a plateau, and stagnating consumption discouraged the development of even existing technologies such as the automobile. After faltering during the war, overheating in the 1920s, and languishing throughout the 1930s in the doldrums of depression, the U.S. economy ceased to be the most dynamic in the world. China succumbed to civil war and foreign invasion, defaulting on its debts and disappointing optimists in the West. Russia suffered revolution, civil war, tyranny, and foreign invasion. Both these giants responded to the crisis by donning the constricting armor of state socialism. They were not alone. By the end of the 1940s, most states in the world, including those that retained political freedoms, had imposed restrictions on trade, migration, and investment as a matter of course. Some achieved autarky, the ideal of a deglobalized society. Consciously or unconsciously, all governments applied in peacetime the economic restrictions that had first been imposed between 1914 and 1918.

The end of globalization after 1914 was not unforeseeable. There was no shortage of voices prophesying Armageddon in the prewar decades. Many popular writers earned a living by predicting a cataclysmic European war. Solemn Marxists had long foretold the collapse of capitalism and imperialism. And Social Darwinists had looked forward eagerly to a conflagration that would weed out the weak and fortify the strong.

Yet most investors were completely caught off guard when the crisis came. Not until the last week of July 1914 was there a desperate dash for liquidity; it happened so suddenly and on such a large scale that the world's major stock markets, New York's included, closed down for the rest of the year. As The Economist put it at the time, investors and financial institutions "saw in a flash the meaning of war." The Dow Jones Industrial Average fell by about 25 percent between January 1910 and December 1913 and remained flat through the first half of 1914. European bond markets, which had held up throughout the diplomatic crises of the 1900s, crashed only at the 11th hour, as the lights went out all over Europe.

Some economic historians detect the origins of the deglobalization that followed World War I in the prewar decades. They point, variously, to rising tariffs and restrictions on migration, a slight uptick in inflation starting around 1896, and the chronic vulnerability of the U.S. economy to banking crises. To this list, it might be added that the risk of further Russian and Chinese revolutions should have been fairly apparent after those of 1905 and 1911, respectively.

The trouble is that none of these problems can be said to have caused the great conflagration that was World War I. To be sure, the prewar world was marked by all kinds of economic rivalries--not least between British and German manufacturers--but these did not suffice to cause a disaster. On the contrary, businessmen on both sides agreed that a major war would be an economic calamity. The point seemed so obvious that war came to be seen by some optimistic commentators as all but impossible--a "great illusion," in the famous phrase of the author Norman Angell. Even when the war broke out, many people optimistically clung to the illusion that it would soon be over. Economist John Maynard Keynes said that it "could not last more than a year."

With the benefit of hindsight, however, five factors can be seen to have precipitated the global explosion of 1914-18. The first cause was imperial overstretch. By 1914, the British Empire was showing signs of being a "weary Titan," in the words of the poet Matthew Arnold. It lacked the will to build up an army capable of deterring Germany from staging a rival bid for European hegemony (if not world power). As the world's policeman, distracted by old and new commitments in Asia and Africa, the United Kingdom's beat had simply become too big.

Great-power rivalry was another principal cause of the catastrophe. The problem was not so much Anglo-German rivalry at sea as it was Russo-German rivalry on land. Fear of a Russian arms buildup convinced the German general staff to fight in 1914 rather than risk waiting any longer.

The third fatal factor was an unstable alliance system. Alliances existed in abundance, but they were shaky. The Germans did not trust the Austrians to stand by them in a crisis, and the Russians worried that the French might lose their nerve. The United Kingdom's actions were impossible to predict because its ententes with France and Russia made no explicit provisions for the eventuality of war in Europe. The associated insecurities encouraged risk-taking diplomacy. In 1908, for example, Austria-Hungary brusquely annexed Bosnia. Three years later, the German government sent the gunboat Panther to Agadir to challenge French claims to predominance in Morocco.

The presence of a rogue regime sponsoring terror was a fourth source of instability. The chain of events leading to war, as every schoolchild used to know, began with the assassination of the Austrian Archduke Franz Ferdinand in Sarajevo by a Bosnian Serb, Gavrilo Princip. There were shady links between the assassin's organization and the Serbian government, which had itself come to power not long before in a bloody palace coup.

Finally, the rise of a revolutionary terrorist organization hostile to capitalism turned an international crisis into a backlash against the global free market. The Bolsheviks, who emerged from the 1903 split in the Russian Social Democratic Party, had already established their credentials as a fanatical organization committed to using violence to bring about world revolution. By straining the tsarist system to the breaking point, the war gave Lenin and his confederates their opportunity. They seized it and used the most ruthless terrorist tactics to win the ensuing civil war.

Parallel Universe

There are obvious economic parallels between the first age of globalization and the current one. Today, as in the period before 1914, protectionism periodically challenges the free-trade orthodoxy. By the standards of the pre-1914 United Kingdom, in fact, the major economies are already shamelessly protectionist when it comes to agriculture. Then, the United Kingdom imposed no tariffs on imported agricultural goods, whereas now the United States, the European Union, and Japan all use tariffs and subsidies to protect their farmers from foreign competition.

Today, no one can be sure how stable the international monetary system is, but one thing is certain: it is no more stable than the system that preceded World War I. Although gold is no longer the basis of the monetary system, there are pegged exchange rates, just as there were in 1914. In Europe, there is a monetary union--essentially a deutsche mark zone. In eastern Asia, there is a dollar standard. Both systems, however, are based on fiat currencies. Unlike before 1914, the core central banks in New York and Frankfurt determine the volume of currency produced, and they do so on the basis of an opaque mixture of rules and discretion.

Today, technological innovation shows no sign of slackening. From nanocomputers the size of a pinhead to scramjets that can cross the Atlantic in an hour, there seems no limit to human ingenuity, given sufficient funding of research and development. That is the good news. The bad news is that now technology also helps the enemies of globalization. Before 1914, terrorists had to pursue their bloody trade with Browning revolvers and primitive bombs. These days, an entire city could be obliterated with a single nuclear device.

Today, as before 1914, the U.S. economy is the world's biggest, but it is now much more important as a market for the rest of the world than it was then. Although the United States may enjoy great influence as the "consumer of first resort," this role depends on the willingness of foreigners to fund a widening current account deficit. A rising proportion of Americans may consider themselves to have been "saved" in the Evangelical sense, but they are less good at saving in the economic sense. The personal savings rate among Americans stood at just 0.2 percent of disposable personal income in September 2004, compared with 7.7 percent less than 15 years ago. Whether to finance domestic investment (in the late 1990s) or government borrowing (after 2000), the United States has come to rely increasingly on foreign lending. As the current account deficit has widened (it is now approaching 6 percent of GDP), U.S. net overseas liabilities have risen steeply to around 25 percent of GDP. Half of the publicly held federal debt is now in foreign hands; at the end of August 2004, the combined U.S. Treasury holdings of China, Hong Kong, Japan, Singapore, South Korea, and Taiwan were $1.1 trillion, up by 22 percent from the end of 2003. A large proportion of this increase is a result of immense purchases by eastern Asian monetary authorities, designed to prevent their currencies from appreciating relative to the dollar.

This deficit is the biggest difference between globalization past and globalization present. A hundred years ago, the global hegemon--the United Kingdom--was a net exporter of capital, channeling a high proportion of its savings overseas to finance the construction of infrastructure such as railways and ports in the Americas, Asia, Australasia, and Africa. Today, its successor as an Anglophone empire plays the diametrically opposite role--as the world's debtor rather than the world's creditor, absorbing around three-quarters of the rest of the world's surplus savings.

Does this departure matter? Some claim it does not--that it just reflects the rest of the world's desire to have a piece of the U.S. economic action, whether as owners of low-risk securities or sellers of underpriced exports. This is how Harvard economist Richard Cooper sees it. Assuming that the U.S. economy has a trend rate of growth of 5 percent a year, he argues that a sustained current account deficit of $500 billion per year would translate into external liabilities of 46 percent of GDP after 15 years, but that then U.S. foreign debt would "decline indefinitely."

Well, maybe. But what if those assumptions are wrong? According to the hsbc Group, the current account deficit could reach 8 percent of GDP by the end of the decade. That could push the United States' net external liabilities as high as 90 percent of GDP. When the United Kingdom accumulated net foreign debts of less than half this percentage, it was fighting World War II. In the war's aftermath, the resulting "sterling balances" owned by the rest of the world were one of the reasons the pound declined and lost its reserve currency status.

A sharp depreciation of the dollar relative to Asian currencies might not worry the majority of Americans, whose liabilities are all dollar-denominated. But its effect on Asia would be profound. Asian holders of dollar assets would suffer heavy capital losses in terms of their own currencies, and Asian exporters would lose some of their competitive advantage in the U.S. market. According to Michael Mussa of the Institute for International Economics, lowering the U.S. deficit to 2 percent of GDP over the next few years would require a further 20 percent decline in the dollar. The economists Maurice Obstfeld and Kenneth Rogoff estimate that the fall could be as much as 40 percent. And the University of California at Berkeley's Brad de Long has pointed out that,

[i]f the private market--which knows that with high probability the dollar is going down someday--decides that that someday has come and that the dollar is going down now, then all the Asian central banks in the world cannot stop it [emphasis in original].

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