The Global Economy Is Now Distinctly Victorian

Op-ed in the Financial Times

August 6, 2013

The global economy is getting back to normal. That does not mean a rapid return to full employment nor to a low-risk world for investors. It means that the underlying realities of globalization are becoming clearer: Ours is a multipolar world, where the technological convergence between rich nations and capable poor ones is rapid. Middle classes are expanding quickly in emerging markets—a group that politicians focus on everywhere, while ignoring recurrent protests from others, particularly low-skilled labor. The world has and will have high real economic volatility despite relative price stability. This state of affairs is, in fact, a return to the Old Normal of the late 19th century. It is a world that we can understand, even if we do not like it.

In international politics, as has long been foretold, the "American century" of 1945–2000 has given way to a world where the United States remains the leader but is losing dominance. So the global system is somewhere between outright conflict and smooth international governance. Reflecting this diffusion of economic and military dominance, a few major currencies—not just one—are increasingly being used for invoicing and reserve management, and that trend will only continue.

The link between currency usage and geopolitical ties is strong, and so the dollar will not be suddenly displaced, but regional alternatives will continue to rise. This has a feel of the 19th century: As Barry Eichengreen, a professor at the University of California, Berkeley has argued, there have been long periods of history where multiple reserve currencies coexisted, like at the end of the 1800s, and we are now in one of those periods—which contributes to economic volatility and uncertainty for national economies and investors.

This multipolar world is also one where no one has sufficient authority to fully protect global public goods, such as intellectual property (IP) rights. A weakening of those protections will increase the pace at which emerging markets capable of converging will catch up with advanced economies. Some see this trend as a result of China's rise or digital piracy, but remember that Germany and the United States reverse engineered British innovations in the Victorian age, and even pirated the IP of Charles Dickens and Arthur Conan Doyle.

At the same time, a lack of IP protection reduces incentives to invest in innovation, as Elhanan Helpman of Harvard has demonstrated. So the technological leaders will advance more slowly, which will also boost catch-up. This, in turn, will erode the relative power of the United States and other advanced economies, further reducing their ability to enforce IP rules. The whole cycle will increase competitive pressure on incumbent multinational businesses.

Active national rivalries, multiple reserve currencies, eroding intellectual property rights, and increased corporate competition in many industries will increase volatility of the real economy and diminish investment. Large state-backed national infrastructure projects, as dominated late 19th century development, will be a growing asset class as a result. The division between investments yielding safer low returns and speculative higher-return assets will be quite sharp.

But as was the case from the 1840s until the first world war, today's convergence and competition—and the volatility that results—can and I believe will persist for a long time without globalization breaking down. It held up for a long time then because, even as there were arms races and conflicts, France and Germany, let alone the United Kingdom and the United States, had an interest in maintaining the status quo. And, as then, today's dominant powers wish to maintain their legitimacy against non-state actors, including terrorists and revolutionaries, and preserve cross-border flows of trade and finance.

Furthermore, politicians are responsive to their own upper middle classes, whose well-being depends upon maintaining globalization and keeping international disputes within limits. These groups are also creditors whose desires for price stability, combined with the pressures from currency competition, creates strong incentives for keeping inflation low. On average, such motivations will dominate over temptations to inflate their problems away. So, just as most countries usually adhered to the gold standard over a century ago, they will stick with independence for their central banks and fiscal consolidation now.

There was little or no response to recurring spasms of protest or calls for radical change by low-skilled workers in the 19th century, except when mass movements were assimilated into mainstream political parties with support from the elites. Something similar is at work today, with the protests of southern Europe and the demands of the Occupy movement largely ignored by policymakers catering to the voters of the (older) bourgeoisie.

The Old Normal is thus a tale of the global economy returning to unfettered markets in many ways, and—at the national level—to more volatile economic conditions with slower average growth as a result. This is a situation which I am predicting, not endorsing. While domestic politics and international relations have changed greatly since 1914, the creation of safety nets and welfare states (even if now curtailed), and the development of nuclear deterrence among the major powers only strengthen the status quo bias of the current governments.

The Old Normal is not nice, but it is likely to last.