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Internationalization and macroeconomic policy
Year after year, international trade accounts for growing shares of GDP in most countries throughout the world. Even the rapid growth of trade, however, seems slow when compared with growth rates for flows of funds between countries. International flows of funds were roughly 6,000% greater than international flows of goods and services during the late 1980s, and this ratio has accelerated into the 1990s. Almost $1 trillion worth of funds flow through international capital markets each day.
Only small shares of these flows of financial capital between countries are used to pay for imbalances of international trade. Instead, they reflect the internationalization of markets for capital. More than 95% of all international flows of money involve (a) arbitrage to make the exchange rates of different currencies equivalent in different markets or (b) speculation in anticipation that exchange rates will change in the near future.
Nevertheless, financial capital flows toward investments that are expected to be the most profitable without regard for national borders. A deposit in a new bank account in Delaware, for example, may be transformed into investment in new manufacturing facilities in South Africa, Bangladesh, or Poland within a few days. Similarly, a transnational corporation headquartered in Australia but seeking funds to finance the hostile takeover of a silicon-chip manufacturer in Hong Kong may find that a broker in Berlin can offer funds at the lowest rate of interest.
The increasing mobility of financial (and ultimately, economic) capital improves the efficiency of economic activity throughout the world. An important side effect is that this mobility reduces the power of domestic monetary and fiscal policymakers everywhere to execute macroeconomic policies that are independent of global developments.
Suppose, for example, that the Fed were concerned about inflation. If the Fed tried to tighten U.S. credit markets by selling U.S. Treasury bonds through open-market operations, this might temporarily exert upward pressures on domestic interest rates. However, the higher U.S. interest rates would quickly attract, say, Japanese savers, who might buy more U.S. Treasury bonds in hopes that interest rates in the United States will soon fall. The net result is that the Fed's contractionary policies could be largely offset by inflows of foreign financial capital. Similarly, expansionary open-market operations might be offset by outflows of financial capital from the United States.
Fiscal policy has also been weakened by the globalization of markets. Suppose a tax cut was initiated to stimulate the economy. The resulting increase in our National Income would be diminished because our higher income would cause us to import more, so that some of the expansionary impetus would be experienced in countries from which we import. Regional economic integration (e.g., the European Community, or the North American Free Trade Agreement between the U.S., Canada, and Mexico) further dilutes the independent power of a country's macroeconomic policymakers, because prosperity or stagnation is diffused through the economies of the country's trading partners.
The internationalization of financial markets ultimately diminishes the power of discretionary policy. Advocates of passive economic policies cite the increasing futility of discretionary policy as one more reason why permanent policies should be established that allow markets to adjust to any economic shocks. 2981 digits