Some of us may remember how I have often pounded the table on behalf of Jude Wanniski's "The Way the World Works" and its hypothesis that the Great Depression was not the result of Wall Street speculation (Dem theory) nor even unsound monetary contraction (Milton Friedman) but rather the fragmentation of the world economy due to tariffs and competitive devaluations.
Some 50 years later, Foreign Affairs begins to catch up.
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The Price of Fragmentation
Why the Global Economy Isn’t Ready for the Shocks Ahead
By Kristalina Georgieva
September/October 2023
Published on August 22, 2023
https://www.foreignaffairs.com/world/price-fragmentation-global-economy-shockWe are living through turbulent times, in a world that has become richer but also more fragile. Russia’s war in Ukraine has painfully demonstrated that we cannot take peace for granted. A deadly pandemic and climate disasters remind us how brittle life is against the force of nature. Major technological transformations such as artificial intelligence hold promise for future growth but also carry significant risks.
Collaboration among nations is critical in a more uncertain and shock-prone world. Yet international cooperation is in retreat. In its place, the world is witnessing the rise of fragmentation: a process that begins with increasing barriers to trade and investment and, in its extreme form, ends with countries’ breaking into rival economic blocs—an outcome that risks reversing the transformative gains that global economic integration has produced.
A number of powerful forces are driving fragmentation. With deepening geopolitical tensions, national security considerations loom large for policymakers and companies, which tends to make them wary of sharing technology or integrating supply chains. Meanwhile, although the global economic integration that has taken place in the past three decades has helped billions of people become wealthier, healthier, and more productive, it has also led to job losses in some sectors and contributed to rising inequality. That in turn has fueled social tensions, creating fertile ground for protectionism and adding to pressures to shift production back home.
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Fragmentation is costly even in normal times and makes it nearly impossible to manage the tremendous global challenges that the world now faces: war, climate change, pandemics. But policymakers everywhere are nevertheless pursuing measures that lead to further fragmentation. Although some of these policies can be justified by the need to ensure the resilience of supply chains, other measures are driven more by self-interest and protectionism, which in the long term will put the world economy in a precarious position.
The costs of fragmentation could not be clearer: as trade falls and barriers rise, global growth will take a severe hit. According to the latest International Monetary Fund projections, annual global GDP growth in 2028 will be only three percent—the IMF’s lowest five-year-ahead forecast in the past three decades, which spells trouble for poverty reduction and for creating jobs among burgeoning populations of young people in developing countries. Fragmentation risks making this already weak economic picture even worse. As growth falls, opportunities vanish, and tension builds, the world—already divided by geopolitical rivalries—could splinter further into competing economic blocs.
Policymakers everywhere recognize that protectionism and decoupling come at a cost. And high-level engagements between the world’s two largest economies, the United States and China, aim to reduce the risks of further disintegration. But broadly speaking, when it comes to trying to turn back the tide of fragmentation, there is a troubling lack of urgency. Another pandemic could once again push the world into global economic crisis. Military conflict, whether in Ukraine or elsewhere, could again exacerbate food insecurity, disrupt energy and commodity markets, and rupture supply chains. Another severe drought or flood could turn millions more people into climate refugees. Nonetheless, despite widespread recognition of these risks, governments and the private sector alike have been unable or unwilling to act.
A more shock-prone world means that economies will need to become much more resilient—not just individually but also collectively. Getting there will require a deliberate approach to cooperation. The international community, supported by institutions such as the IMF, should work together in a systematic and pragmatic manner, pursuing targeted progress where common ground exists and maintaining collaboration in areas where inaction would be devastating. Policymakers need to focus on the issues that matter most not only to the wealth of nations but also to the economic well-being of ordinary people. They must nurture the bonds of trust among countries wherever possible so they can quickly step up cooperation when the next major shock comes. That would benefit poorer and richer economies alike by supporting global growth and reducing the risk that instability will spread across borders. Even for the richest and most powerful countries, a fragmented world will be difficult to navigate, and cooperation will become not only a matter of solidarity but of self-interest, as well.
A FRAGILE WORLD
Two world wars in the twentieth century revealed that international cooperation is critical for peace and prosperity and that it requires a sound institutional foundation. Even as World War II was still raging, the Allies came together to create a multilateral architecture that would include the United Nations and the Bretton Woods institutions—the IMF and the World Bank—together with the precursor to the World Trade Organization. Each organization was entrusted with a special mandate to address the problems of the day requiring collective action.
What ultimately followed was an explosion of trade and integration that transformed the world, culminating in what came to be known as globalization. Integration had accelerated in previous historical eras, especially in the wake of the Industrial Revolution. But during the world wars and the interwar period, it had sharply retreated, and in the immediate postwar era, the fragmentation of the Cold War threatened to prevent it from recovering. The international security and financial architecture the Allies built, however, allowed integration to come roaring back. Since then, that architecture has adapted to massive changes. The number of countries in the world has grown from 99 in 1944 to nearly 200 today. In the same period, the earth’s population has more than tripled, from around 2.3 billion to around 8.0 billion, and global GDP has increased more than tenfold. All the while, the expansion of trade in an increasingly integrated global economy has delivered substantial benefits in terms of growth and poverty reduction.
These gains are now at risk. After the 2008 global financial crisis, a period of “slowbalization” began, as growth became uneven and countries began imposing barriers to trade. Convergence in living standards within and across countries has stalled. And since the pandemic began, low-income countries have seen a collapse in their per capita GDP growth rates, which have fallen by more than half, from an average of 3.1 percent annually in the 15 years before the pandemic to 1.4 percent since 2020. The decline has been much more modest in rich countries, where per capita GDP growth rates have fallen from 1.2 percent in the 15 pre-pandemic years to 1.0 percent since 2020. Rising inequality is fostering political instability and undermining the prospects for future growth, especially for vulnerable economies and poorer people. The existential threat of climate change is aggravating existing vulnerabilities and introducing new shocks. Vulnerable countries are running out of buffers, and rising indebtedness is putting economic sustainability at risk.
In a more fragile world, countries (or blocs of countries) may be tempted to define their interests narrowly and retreat from cooperation. But many countries lack the technology, financial resources, and capacity to successfully contend with economic shocks on their own—and their failure to do so will harm not only the well-being of their own citizens but also that of people elsewhere. And in a less secure world with weaker growth prospects, the risk of fragmentation only grows, potentially creating a vicious downward spiral.
Should this happen, the costs will be prohibitively high. Over the long term, trade fragmentation—that is, increasing restrictions on the trade in goods and services across countries—could reduce global GDP by up to seven percent, or $7.4 trillion in today’s dollars, the equivalent of the combined GDPs of France and Germany and more than three times the size of the entire sub-Saharan African economy. That is why policymakers should reconsider their newfound embrace of trade barriers, which have proliferated at a rapid clip in recent years: in 2019, countries imposed fewer than 1,000 restrictions on trade; in 2022, that number skyrocketed to almost 3,000.
As protectionism spreads, the costs of technological decoupling—that is, restrictions on the flow of high-tech goods, services, and knowledge across countries—would only add to the misery, reducing the GDPs of some countries by up to 12 percent over the long term. Fragmentation can also lead to severe disruption in commodity markets and create food and energy insecurity: for example, Russia’s blockade of Ukrainian wheat exports was a key driver behind the sudden 37 percent increase in global wheat prices in the spring of 2022. This drove inflation in the prices of other food items and exacerbated food insecurity, notably in low-income countries in North Africa, the Middle East, and South Asia. Finally, the fragmentation of capital flows, which would see investors and countries diverting investments and financial transactions to like-minded countries, would constitute another blow to global growth. The combined losses from all facets of fragmentation may be hard to quantify, but it is clear that they all point to lower growth in productivity and in turn to lower living standards, more poverty, and less investment in health, education, and infrastructure. Global economic resilience and prosperity will depend on the survival of economic integration.
A GLOBAL SAFETY NET
In a world with more frequent and severe shocks, countries have to find ways to cushion the adverse impacts on their economies and people. That will require building economic buffers in good times that can then be deployed in bad times. One such buffer is a country’s international reserves—that is, the foreign currency holdings of its central bank, which provide a readily available source of financing for countries when hit by shocks. In the aggregate, reserves have grown tremendously over the past two decades, on par with the expansion of the world economy and in response to financial crises. But those reserves are heavily concentrated in a relatively small group of economically stronger advanced and emerging market economies: just ten countries hold two-thirds of global reserves. In contrast, reserve holdings in most other countries remain modest, especially in sub-Saharan Africa, parts of Latin America, oil-importing states in the Middle East, and small island states—which, taken together, account for less than one percent of global reserves. This uneven distribution of reserves means that many countries remain highly vulnerable.
No country should rely on its reserves alone, of course. Consider how a household, which cannot save enough money for every conceivable shock, purchases insurance for a home, a car, and health care. Similarly, countries are better off if they can complement their own reserves with access to various international insurance mechanisms that are collectively known as “the global financial safety net.” At the center of the net is the IMF, which pools the resources of its membership and acts as a cooperative global lender of last resort. The net is buttressed by currency swap lines, through which central banks provide one another with liquidity backstops (typically to reduce financial stability risks), and by financing arrangements that allow countries within specific regions to pool resources that can be deployed if a crisis hits.
Protecting countries and their people against shocks contributes to stability beyond their borders: such protection is a global public good. A global safety net that pools international resources to provide liquidity to individual countries when they are struck by calamities is thus in the interest of individual countries and the world. The COVID-19 crisis provides a good example. With the pooled resources of the IMF, member countries received liquidity injections at an unprecedented speed and scale, helping them finance essential imports such as medicines, food, and energy. Since the pandemic, the IMF has approved over $300 billion in new financing for 96 countries, the broadest support ever over such a short period. Of this, over $140 billion has been provided since Russia’s invasion of Ukraine to help the fund’s members address financing pressures, including those resulting from the war.
Although the global financial safety net helped manage the fallout from COVID and the effects of Russia’s invasion, it is sure to be tested again by the next big shock. With reserves unevenly distributed, there is a pressing need to expand the world’s pooled resources to insure vulnerable countries against severe shocks. The IMF’s nearly $1 trillion in lending capacity is now only a small part of the overall safety net. Although self-insurance through international reserves has sharply increased for some countries, pooled resources centered on the IMF have increased far less than self-insurance and have shrunk markedly relative to measures of global financial integration. That is why the international community must strengthen the global financial safety net, including by expanding the availability of pooled resources in the IMF.
DEALING WITH DEBT
Even if the global financial safety net is strengthened, some countries might exhaust their buffers in the face of global economic shocks and accumulate economic imbalances over time—notably, higher fiscal deficits and rising debt levels. Although debt is up everywhere, the problem is particularly acute for many vulnerable emerging-market and low-income countries as a result of recent economic jolts, rising interest rates, and, in some cases, policy errors on the part of governments. By the end of 2022, average debt levels in emerging-market countries had reached 58 percent of GDP, a significant increase from a decade earlier, when that figure stood at 42 percent. Average debt levels in low-income countries had increased even more sharply over that period, from 38 percent of GDP to 60 percent. About one-quarter of emerging-market countries’ bonds are now trading at spreads indicative of distress. And 25 years after the launch of a broad-based international debt relief initiative for poor countries, about 15 percent of low-income countries are now considered to be in debt distress, with another 40 percent at risk of ending up in that situation.
The costs of a full-blown debt crisis are most keenly felt by people in debtor countries. According to one analysis by the World Bank, on average, poverty levels spike by 30 percent after a country defaults on its external obligations and remain elevated for a decade, during which infant mortality rates rise on average by 13 percent and children face shorter life expectancies. Other countries are affected as well. Savers lose their wealth. Borrowers’ access to credit can become more limited.
To ensure debt sustainability in a world of more frequent climate and health calamities, individual countries and international organizations must do everything they can to prevent the unsustainable accumulation of debt in the first place—and failing that, to support the orderly restructuring of debt if it becomes necessary. If debt crises multiply, the gains that low-income countries have made in recent decades could quickly evaporate. To prevent that from happening, international institutions can help countries focus on economic reforms that would spur growth, improve the effectiveness of budgetary spending, enhance tax collection, and strengthen debt management.
Reducing the costs of debt crises means resolving them quickly. Doing so is not easy. The creditor landscape has changed significantly over the past several decades, with new official creditors such as China, India, and Saudi Arabia entering the scene and the variety of private creditors expanding dramatically. Quick and coordinated action by creditors requires mutual trust and understanding, but the increase in the number and type of creditors has made that more challenging, especially since some key creditors are divided along geopolitical lines.
The IMF’s financial model and policies need a refresh.
Consider the case of Zambia, Africa’s second-biggest copper producer. Over the past decade, it ramped up spending on public investment financed by debt, but economic growth failed to follow, and the country ran out of resources to meet its debt repayments, defaulting in 2020. Its official creditors took almost a year to agree to a deal to restructure billions of dollars of loans. This milestone required the mostly high-income group of creditors known as the Paris Club to cooperate with the new creditor countries. But the job will be fully complete only when private creditors also come forward and agree to a comparable deal with Zambia—work that is already underway.
Although reaching an agreement for Zambia took time, official creditors have been learning how to work together, in this case under a Common Framework established by the G-20. The technical discussions taking place through the new Global Sovereign Debt Roundtable—initiated in February 2023 by the IMF, the World Bank, and the G-20 under India’s presidency—are also helping build a deeper common understanding across a broader set of stakeholders, including the private sector and debtor countries. This development holds promise for highly indebted countries, such as Sri Lanka and Ghana, that still need the international community to decisively follow through on commitments to provide critical debt relief.
But creditors and international financial institutions must do more. Debtors should receive a clearer road map of what they can expect from creditors in the timing of key decisions. Creditors also need to find ways to more quickly clear hurdles to reaching consensus. For instance, earlier information sharing can help creditors and debtors resolve debt crises in a more cooperative fashion, with help from institutions such as the IMF. And if private creditors demonstrate that they can do their part and provide debt relief on terms comparable to those offered by official creditors, it will reassure the official creditors and give them the confidence to move faster.
International financial institutions and lenders must also develop mechanisms to insure countries against debt crises in the event of major shocks. Such mechanisms play a crucial role in ensuring that a liquidity crunch does not tip countries into more costly debt distress. One promising idea would be to take a contractual approach to commercial debt. This could involve including clauses in debt contracts that would automatically trigger a deferral of debt repayments if a country experienced a natural disaster such as a flood, drought, or earthquake.
Debtors must do their part, too, starting by being more proactive when it comes to risk mitigation, and better coordinating their debt management strategy with fiscal policy. Governments must also show a willingness to tackle the underlying policy mistakes at the heart of more fundamental debt challenges. For instance, Zambia’s strong commitment to undertaking necessary economic reforms, such as removing fuel subsidies that mostly benefited wealthier households, meant that the IMF could move forward with its own financial support and that official creditors were more willing to provide debt relief.
THE FIGHT AGAINST FRAGMENTATION
The IMF has long played a central role in the global economy. It is the only institution empowered by its 190 members to carry out regular and thorough “health checks” of their economies. It is a steward of macroeconomic and financial stability, a source of essential policy advice, and a lender of last resort, poised to help protect countries against crises and instability. In a world of more shocks and divisions, the fund’s universal membership and oversight are a tremendous asset.
But the IMF is just one actor in the global economy and just one among many important international financial institutions. And to keep up with the pace of change in a fragmenting world, the fund’s financial model and policies need a refresh. An important first step would be completing the 16th General Review of Quotas. The IMF’s quota resources—the financial contributions paid by each member—are the primary building blocks of the fund’s financial structure, which pools the resources of all its members. Each member of the IMF is assigned a quota based broadly on its relative position in the world economy, and the IMF regularly reviews its quota resources to make sure they are adequate to help its members cope with shocks. An increase in quotas would provide more permanent resources to support emerging and developing economies and reduce the fund’s reliance on temporary credit lines. It is essential that the IMF’s membership come together to bolster the institution’s quota resources by completing the review by the December 2023 deadline.
The IMF’s better-off members need to make a concerted effort to urgently replenish the financial resources of the Poverty Reduction and Growth Trust. The trust, which is administered by the IMF, has provided almost $30 billion in interest-free financing to 56 low-income countries since the onset of the pandemic, more than quadruple its historical levels. This funding is critical to ensure that the IMF can continue meeting the record demand for support from its poorest member countries. And to address the economic risks created by climate change and pandemics, the fund’s better-off members should also scale up their channeling of Special Drawing Rights (an IMF reserve asset, which it allocates to all its members) to more vulnerable countries through the fund’s newly created Resilience and Sustainability Trust.
The IMF must also continue working to enhance representation inside the organization. It is important that the fund reflect the economic realities of today’s world, not that of the last century. Decision-making at the fund requires a highly collaborative approach and inclusive governance. This would support more agility and adaptability in the IMF’s policies and financing instruments to better serve the needs of its members.
Reducing the costs of debt crises means resolving them quickly.
Finally, the IMF cannot be truly effective in today’s fragmented world unless it continues to deepen its ties with other international organizations, including the World Bank, other multilateral development banks such as the African Development Bank, and institutions such as the Bank for International Settlements and the World Trade Organization. All those international financial institutions must join forces to foster international cooperation on the most pressing challenges facing the world.
In 1944, the 44 men (and zero women) who signed the Bretton Woods agreement sat at one table in a modestly sized room. The small number of players was an advantage, as was the fact that most of the countries represented were allies fighting together in World War II. Today, finding consensus among 190 members is much more difficult, especially as trust among different groups of countries is eroding and faith in the ability to pursue the common good is at an all-time low. Yet the world’s people deserve a chance at pursuing peace, prosperity, and life on a livable planet.
For nearly 80 years, the world has responded to major economic challenges through a system of rules, shared principles, and institutions, including those rooted in the Bretton Woods system. Now that the world has entered a new era of increasing fragmentation, international institutions are even more vital for bringing countries together and solving the big global challenges of today. But without enhanced support from higher-income countries and a renewed commitment to collaboration, the IMF and other international institutions will struggle.
The period of rapid globalization and integration has come to an end, and the forces of protectionism are on the rise. Perhaps the only thing certain about this fragile, fragmented new global economy is that it will face shocks. The IMF, other international institutions, creditors, and borrowers must all adapt and prepare. It’s going to be a bumpy ride; the international financial system needs to buckle up
