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Introduction to Globalization
For over a year now, the anticipated changes in interest rates have been the primary driver for global financial markets. With this in mind, we’re interested in diving into the key factors driving inflation in the short and long term, an understanding that will help us better anticipate future market movements.
In Part 1 of our ‘Inflation’ series, we focused on how supply & demand mismatches can cause a short-term price dislocation that drives inflation. In this part, we’ll dive deep into some of the critical ways that globalization has contributed to a low inflationary environment.
Unsurprisingly, globalization has and continues to play a significant role in the production and demand for goods and services. The push for our modern globalized world, where free trade rules, dates back, at a minimum, to the rise of the United States as a production superpower in the 19th and 20th centuries. America's foreign policy strategy was centered on leading the global free trade market, and this agenda was driven by the fact that the country was a low-cost, efficient producer of goods. As such, the global free markets would allow other countries to purchase better goods at lower prices from the new world.
Globalization Today
We have come a long way since then — we live in a highly interconnected world where goods are produced across a large group of countries. If we take the production of a smartphone, for instance, components like the battery, processor, and screen may be sourced from countries such as China, Japan, South Korea, and Taiwan. Meanwhile, the final assembly is likely to take place in an entirely different manufacturing country, such as Vietnam or India. As we can see, globalization has made room for more optimal low-cost production of goods with improved overall quality, largely due to specialization and collaboration between countries.
The efficiency of globalization is a strong deflationary force, one where the prices of goods and services are going down. This type of deflation is excellent for most, as it allows entire societies to consume more goods for less cost and frees up resources to focus on other, more specialized production areas.
As such, this has been one of the defining factors of why interest rates have been able to stay so low for so long, giving central banks the ability to print money to combat deflation and keep inflation stable and low.
China has been a significant benefactor of globalization and is crucial to this story — their ability to produce efficiently and at low cost has been immense over the past 30 years. Looking at your current surroundings, you will likely recognize that most of these items are made in China. China has also been diversifying out of this space, focusing on transitioning into services, high-end technology, data, and healthcare.
Globalization Looking Forward
Over the past 5 years, it is very evident that the American strategy has been shifting away from full-fledged globalization. The Trump administration’s tariffs on Chinese goods has been followed by Biden’s further decoupling through policies such as the restricted access to semiconductors. To add to this, our present world is seeing a clear decoupling between most of the West from Russia.
A less globalized world is the primary risk to current markets. If we continue to see this trend of transitioning into a less connected world, we can continue to see high inflationary pressures.
With this type of inflation, where the production of goods and services is hindered, we are unlikely to see monetary policy having any material effect on combating inflation. For this type of challenge, the only viable solution is to increase the efficiency in production to offset the loss from globalization.
Conclusion
With all of this said, the jury is still out on this topic —as much as there has been rhetoric and forces towards a more separated world, we are as interconnected as we have ever been and are still moving forward in this direction. Having transitioned to a world where data is central to everything we do, cross-border data flows have been increasing in a dramatic fashion confirming our continued interdependence on each other globally:
IMF data confirms that global trade has increased dramatically over the past three years. And although the headlines will make you think otherwise, US-China trade consistently continues to grow. As much as there is political rhetoric about transitioning into a more fractioned world, it seems that there will be strong economic resistance in this path towards more production at lower costs.
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