Implications of the Globalisation of Financial Markets


This article reproduces the main text of a Treasury submission to the House of Representatives Standing Committee on Economics, Finance and Public Administration inquiry into the implications of the globalisation of international financial markets for macroeconomic policy and the operation of financial markets.

The submission was lodged in September 1999 and is available in full on the Committees website at

Introduction 72

Terms of Reference 1 86

Managing globalisation in the 1990s 86

Effectiveness of macroeconomic policy in a globalised world 90

Globalisation and Australian economic development 95

Terms of Reference 2 101

Greater transparency 102

International codes and standards 106

The role of surveillance 109

Terms of Reference 3 111

Soundly based liberalisation and more stable capital flows 111

Strengthening domestic financial systems, macroeconomic and

regulatory policies 116

Strengthening the international financial system 118

Bibliography and References 126


  1. The globalisation of financial markets has attracted particular public attention through the 1990s, as one striking aspect of a longer, general trend to increasing globalisation.

  2. One aspect of globalisation, the globalisation of financial markets, is complex and only imperfectly understood. Many question whether it has given rise to, or amplified, shocks to global economic activity. They point to the 1987 stockmarket crash and four major international currency and economic crises in the 1990s: the crisis affecting the EUs Exchange Rate Mechanism in 1992-93, the Mexican crisis in 1994-95, the Asian crisis of 1997-98 and the Russian crisis of 1998.

  3. It is also frequently suggested that globalisation has reduced the scope for independent macroeconomic policy action by national governments, damaged the quantity or quality of employment growth in advanced economies, widened the dispersion of income, and so on.

  4. So globalisation in general, and especially financial globalisation, often get a bad press. Even those who accept globalisation as inevitable or irreversible, and who focus on how best to adapt to its forces at the national or international level, often do so without paying much attention to the positive potential of globalisation in a sound policy framework to improve national and global welfare.

  5. This submission focuses mainly on the three major clauses in the Inquirys terms of reference in the context of financial globalisation, rather than on the broader social issues raised by globalisation in general. However, to analyse the three topics posed by the Inquiry, we first set the economic scene by considering the definition and the nature of economic globalisation. We offer some brief comments on the forces propelling it, the nature of its potential benefits and costs, and some of the unusual factors influencing the globalisation of financial markets.

Definitions and scope

  1. Globalisation is a concept that is frequently left undefined or defined almost circularly as internationalisation.

  2. One of the more careful definitions of globalisation stresses the geographical dispersion of industrial and service activities (for example research and development, sourcing of inputs, production and distribution) and the cross-border networking of companies (for example through joint ventures and the sharing of assets). Such concepts of globalisation focus on the movement of economic activities around the world from their original homes in domestic corporations, and the impact of those shifts on the nature of domestic corporations and employment.

  3. Is such globalisation any more than contemporary shorthand for the increasing cross-border flows of goods, services and finance? It is useful to examine whether globalisation is a fundamentally new economic phenomenon, or whether it is simply a useful label for todays form of a very old phenomenon: the tendency towards increasing specialisation and trade, with the associated implications for increased financial flows.

A brief history of globalisation

  1. Increasing specialisation and trade have been key contributors to social progress since humanitys emergence from the rigours of subsistence, hunter-gatherer life in prehistoric times.

  2. Down through history, specialisation and trade increased progressively beyond the village to the province, the country, the region and the world. At each stage, the boundaries to profitable specialisation and trade were influenced mainly by technology, broadly defined. Especially relevant in expanding those boundaries were the physical technologies which lowered production costs and transport costs, and the social technologies embodied in social institutions which facilitated finance, contract enforcement and payment. The evolution of social technologies became particularly important as economic relations intensified across national boundaries, encountering new risks such as losses in transport, difficulties in enforcing deals with distant, anonymous counterparties, disputes about timely payment, and so on. (For example, marine insurance had emerged in simple form by 1800 BC, and developed during the Roman empire, but insurance only blossomed as a generalised concept of wide commercial application in the 18th century.)

  3. With each extension of the boundaries to profitable specialisation and trade, living standards rose. Particularly rapid rises in living standards attended major technological and social innovations in the 18th and 19th centuries. The technological drivers of economic progress were particularly apparent in the 19th century, when steam engines powered specialised machinery to increase productivity in factories; canals, railways and steamships radically lowered transport costs; and the telegraph lowered the costs and increased the speed of communications. The earlier emergence and evolution of commercial technologies such as the joint stock, limited liability corporation, and the application or spread of more sophisticated means of risk management such as insurance, forward contracts, futures and options contracts were vital to financing the construction, operation and trade in the products of the new physical technologies.

  4. At every stage of these increases in specialisation and trade, unanticipated consequences and occasional crises had to be corrected in the light of experience. To give just a few examples: the interaction of credit facilities and an early form of options with physical asset markets allowed a price bubble and crash in tulip bulbs in the 17th century; and the introduction of steam locomotives caused fires and destroyed crops and agricultural property adjoining railway lines; common law had to evolve (and subsequently statutory law was passed) to assign responsibilities and award damages, which encouraged railway operators to fit spark-arresters to locomotives.

  5. The progress of specialisation and growth in trade was of course not smooth, but ebbed and flowed through history with many influences, including policy changes. For example the repeal of the Corn Laws in 1846 w
    hich ushered in Britains embrace of free trade, probably contributed, together with the technological advances of that era, to accelerated world trade growth.

  6. At the macroeconomic level, it seems likely that by the end of the 19th century, globalisation in the sense of net annual international trade and capital flows as a proportion of contemporary GDP, was about as advanced as it is today. For example most industrial economies trade-to-GDP ratios were almost as big as todays. Net capital flows were already actually larger relative to GDP than they are today (though there is no doubt gross capital flows are now much higher ¾ and of course much more quickly responsive to new information ¾ than 100 years ago). To put the same observation another way, the correlations between domestic savings and investment rates were actually lower at the turn of the last century than today, so that net saving countries lent or invested more funds to net borrowing countries that had profitable investment opportunities than today. Australia even then was a principle beneficiary of those capital flows, averaging a current account deficit (CAD) of 3.7 per cent of GDP from 1880 to 1913. Canadas performance was even more remarkable, averaging a 7.7 per cent CAD over the same period. European countries stocks of direct investment abroad were much larger relative to GDP at the end of last century than they are today. Even international labour flows were larger then than now.

  7. The potential risks of such high international links were managed quite differently then than now. For example, exchange rate risks were prevented by the gold standard, and other international commercial and political risks in trade and investment were limited by the fact that international flows took place largely within colonial links.

  8. Today, however, the high degree of globalisation at the end of the 19th century is largely forgotten, because benchmarks in living memory have been set by the beggar-thy-neighbour rounds of tariff escalations, competitive exchange rate depreciations and the erection of capital controls that accompanied the Great Depression.

  9. Trade barriers erected in the Great Depression only began to be dismantled in earnest after World War II, with the creation of the General Agreement on Tariffs and Trade (GATT). Governments of the industrial economies cut tariffs by some 90 per cent through successive GATT rounds of bargaining through to the early 1990s, and that extended process contributed to the leading role of trade growth in stimulating overall economic growth in the second half of this century.

  10. In contrast to this slow but steady trade liberalisation, capital controls were maintained until after the breakdown of the Bretton Woods arrangements from 1971 to 1973, and persisted in minor form in such major economies as France and Italy until as recently as 1990. One reason financial globalisation has recently proceeded so fast is that it was repressed by capital controls for so long.

  11. So the degree of international trade and capital flows at the end of the 20th century is not unprecedented. Rather, in modern times it is the heights of trade and capital restrictions in the inter-War era that should be regarded as exceptional.

  12. Seen against this historical background, the current, distinctive element of globalisation can be considered in large part to be a particular type of technological change in the 1980s and 1990s: the precipitous fall in the cost of information technology, including semiconductors, computers, software and telecommunications. Since 1964, the real cost of processing information has fallen more than 95 per cent.

  13. This fall in the cost of IT has greatly reduced the cost of producing and trading in many services. This technological change interacted with great social and institutional innovation in subcontracting, outsourcing or licensing many aspects of work. It seems likely that the development of international standards in important commercial areas such as accounting and auditing has also contributed. Together, these developments facilitated greater specialisation and international trade, particularly in many services that could previously only be supplied within national or regional boundaries (or even only within the boundaries of the firm itself).

  14. Current interesting examples of such globalisation include an Australian computer booking centre for an international airline headquartered in Asia, and international shared service centres, such as Infinium, a joint venture in Singapore by Exxon and Shell to provide outsourced global accounting services to the global operations of both corporations, including their American and European head offices. Such operations, and hundreds of others like them, would have been commercially inconceivable even 20 years ago (being prohibitively expensive with then-prevailing computing and communication technologies, and therefore bound to in house provision in metropolitan corporate headquarters.)

  15. The other reminder from inter-war history is that, contrary to popular contemporary claims, globalisation is not necessarily irreversible: it was in fact reversed very effectively in the second quarter of this century. The more pertinent observation is that that reversal cost us all very dearly, because it involved the sacrifice of the gains of specialisation and international trade. (We would hope that globalisation would in practice be more difficult to reverse today than in the Great Depression. Reasons include: the institutional foundations for international commerce and finance are now sounder; the commitments to avoiding protectionism are now embedded in a multilateral treaty and other multilateral commitments (such as in APEC), rather than only in an incomplete network of bilateral treaties; and the social safety nets, private insurance and macroeconomic automatic stabilisers that mitigate welfare losses in economic downturns are now much larger.)

Financial globalisation

  1. Increased international trade in goods and services is inextricably linked to increased international financial flows through complex relationships.

  2. At the microeconomic level, any international trade in a good or a service gives rise to associated international payment transactions, and frequently generates the international provision of additional financial services such as bankers acceptances or letters of credit, or hedging in futures or options markets to manage risks of changes in exchange rates or other prices.

  3. Paradoxically, even the impossibility or prohibitive cost of trading some goods can also give rise to an international flow of investment (for example to finance foreign direct investment to produce that good behind a national protective barrier), or of finance (for example in licence fees for a local producer to manufacture a product using a technology or a brand owned abroad).

  4. At the macroeconomic level, if a country invests more than it saves, or consumes more than it produces, it must import capital ¾ ie run a capital account surplus equal and opposite to its current account deficit. So the levels and patterns of the worlds net international capital flows in any period are determined by the large constellation of influences that set countries savings, investment, GDP and GNE. However, gross international financial
    flows can be many times larger than net flows, and it is these gross flows that are now at unprecedentedly high levels, and whose volatility has become of growing concern.

Reasons for the growth of international financial transactions

  1. International gross financial flows have mushroomed over the last 25 years for many reasons, including:

  • trade has expanded at roughly twice the rate of GDP growth, international direct investment at roughly three times the rate, and international equity investment at some ten times that rate;

  • risks of exchange rate movements expanded with the end, between 1971 to 1973, of the Bretton Woods system of fixed exchange rates. So traders and producers had to find new ways of managing those risks, and to use existing methods of risk insurance more intensively;

  • capital controls were abolished in the US and Germany almost immediately after the end of fixed exchange rates, in the UK in 1979, in Japan in 1980, in Australia in 1983, but in France and Italy not wholly until 1990;

  • financial innovation has expanded the range of available derivative instruments for pricing and trading the risks associated with the preceding three factors, and businesses have found it useful to pay to use those instruments;

  • demographic changes in some of the advanced economies have increased the size of pension funds, which in turn have increasingly sought international portfolio equity investments to form an internationally diversified portfolio of high yields to reduce home country risks;

  • competition in financial service provision has cut costs. For example average commissions on UK equities trading fell by around two thirds over the period 1980 to 1992, and average commissions on Eurodollar bond issues fell by around 40 per cent between 1980 and 1987; and

  • perhaps most importantly in recent years, information technology advances have greatly reduced the costs of international communication, and of managing and transferring funds.

  1. Since communication and financial transaction costs are a relatively large part of the costs of doing international financial business, the effect of advances in IT on global capital markets has been even larger than their effects on the broader economy.

1 One OECD study, Globalisation of Industrial Activities: Four Case studies: Auto Parts, Chemicals, Construction and Semiconductors (1992) offers no definition, but speaks merely of a 'third phase of internationalisation', with characteristics roughly corresponding to the fuller definition in paragraph 7. In another example, John Clark's Dictionary of Banking and Finance Terms defines globalisation (somewhat circularly) as simply 'Increasing internationalization of all markets, industries and commerce' (Prospect, Sydney, 1999) p. 166.

2 This definition is cited in the Penguin Dictionary of Economics, by Bannock, G., Baxter R. E. and Davis, E., 1998, sixth edition, Penguin Books, London, pp. 176-177. It is said in turn to be drawn from the OECD usage.

3 To attribute such a central role to specialisation, division of labour and trade is not to conceive of human progress solely in materialistic terms: a society with a high degree of specialisation and division of labour is a prerequisite to the existence of professional teachers, philosophers, composers, priests and politicians. For a discussion of the likely role of specialisation and trade in the pre-historic emergence of civilisation, see Diamond, J. Guns, Germs and Steel: the Fates of Human Societies, Jonathan Cape, London, 1997, pp. 61-66. Plato also clearly analysed the central role of specialisation and trade in an ideal city, some 2,400 years ago. See The Republic of Plato, translated by Bloom, A. Basic Books, New York, 1968, pp. 46-51.

4 It is unusual to conceive of the social institutions of commerce as 'technological' innovations, but they arose endogenously and spread within communities in response to just the same sort of trial-and-error experimentation as selected superior strains of grain for farming, or devised better tools for making shoes. Thinking of social and commercial innovation with this 'technological' analogy can be particularly helpful to considering the nature and implications of today's globalisation, especially financial globalisation.

5 Bernstein, P. L. Against the Gods: the Remarkable Story of Risk, John Wiley and Sons, New York, 1996, p. 92.

6 Ibid, pp. 1-8, 88-96 and 304-328

7 See Kindleberger, C. P. Manias, Panics and Crashes: A History of Financial Crises, 1978, Basic Books, New York, and Coase, R. H. The Problem of Social Cost, Journal of Law and Economics Vol III October 1960, pp. 1-44, esp pp. 29-34.

8 Bhagwati, J. (1988) Protectionism, MIT Press, Cambridge Massachusetts, pp. 17-23.

9 Bayoumi, T. 'Saving - Investment Correlations', IMF Staff Papers Vol 37 No 2, pp. 360-387, 1990, cited in NZ Treasury Working Paper 99/6, Economic Integration and Monetary Union, by Andrew Coleman.

10 Woodall, P. 'Survey of the World Economy: the hitchhiker's guide to cybernomics', The Economist, 28 September 1996. See also The Economist 18 October 1997.

11 Smith, C. W. Globalization of Financial Markets, Carnegie-Rochester Conference Series on Public Policy, Volume 34 Spring 1991, North Holland, pp. 77-96.

12 See Florence Chong, Two to Tango, The Australian, 15 June 1999, p. 32.

13 We abstract from the special case of countertrade, an inefficient process associated with either the birth of international trade in goods in the absence of developed payments machinery, temporary measures in response to catastrophic economic disruptions, or ideological considerations which shaped the trade relations among the former communist bloc.