Don’t Blame Greeks Part II

How global economy transit domestic shocks.

May 25, 2010

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GreekChorus-1Market reforms, the lowering of tariff barriers, free-trade agreements – arguably they have made for the transmission of the best economic practices, improving productivity, freeing up stagnant economic sectors for innovation and improving returns for investors now presented with a global opportunity set instead of the same old home-market bias.

But with freer flows of capital, regional and country correlations have increased, creating what looks like a global stock market in sync. Well, at least in times of crisis – when almost by definition all correlations go to one (except for U.S. Treasuries). So there’s no safe haven from bearish market participants.

The flip – or volatile – side of this is that domestic problems are transmitted with almost equal rapidity into the global liquidity pool or so argue Alina Carare and Ashoka Mody, researchers at the IMF’s European Department.

We have Greece to thank for that rude lesson over the past few weeks. But it’s not just Greece. In their article: “Spillovers of domestic shocks: Will they counteract the ‘Great Moderation’?,” Carare and Mody note:

“While the extreme volatility that the world has recently witnessed could not have been anticipated, it should not have come as a complete surprise. The ‘Great Moderation’ – an extended period of declining output and inflation volatility – was a robustly established trend in a large number of industrialized nations. However, most of the papers analyzing these trends did not factor in the ongoing integration of the global economy; even when considering multiple countries, they have typically dealt with individual country experiences. Did the extended reach of finance and trade not make a difference in global output growth volatility trends?”

Such volatility is related to “vertical specialization” – integrated supply chain management across economies: in other words, taking an engine from one country and mixing it with parts from another  and assembling them into a car sold in one or more countries. It’s a variation on comparative advantage, where one country trades with another, each producing what they do best: corn, autos, oil.

So diversification doesn’t work as well as it did in the past, not for investments, not for economies, the authors report.

“If we are correct in the mechanism identified for the transmission of the shocks – vertical specialization – the vulnerability is likely to persist. Vertical specialization is a benign force for global growth and welfare but can turn rapidly to amplify downturns.”

That said, the cure for globalization appears to be more of the same.

“Countries responded ex post to the urgency of the recent crisis by coordinating (to varying degrees) financial, monetary, and fiscal policies. Looking ahead, all countries have a stake in the policy stance and approaches of other countries.”

With trade, evidently, comes mutual responsibility.

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