The Puzzle of the World Economy
Forrest Cookson unravels the inner workings of our global markets
For the past eight years, the world economy has expanded quite nicely with fairly rapid growth of the major economies. Japan lagging slightly but catching up, and China and India growing very rapidly with powerful effects on the rest of the world.
Throughout this period, there was grave concern about the underlying forces at work, and the recognition that, sooner or later, major adjustments would be needed. How large and how difficult such corrections would be was the source of considerable argument, with a healthy number of both pessimists and optimists.
In 2007, the underlying problems with the functioning of the world economy began to emerge. Now the puzzle is whether we will return to more of the same, or is there going to be a major change.
The conclusion put forward here is that we will return to the successful equilibrium of the past few years, and delay further the adjustments that most economists believe are needed and are inevitable. But who knows?
How does the world economy work?
One of the ways to raise your economic welfare is to be able to print paper that other people will accept as money, allowing you to buy the things they make with the money that you print. In world economy, the role of the US dollar is just that. If nations or people want to hold dollars, either in bank accounts or currency, then the United States citizens can buy things that other countries make without sending them something in return. For the past 60 years, because the United States dollar has been the currency used in international trade and the desired currency which governments and people held for their reserves, this extra advantage accrued to the United States. The United States, in return, was obligated to ensure that the dollar was strong, and that American economic and financial policies and laws were prudent and protected the foreign investor.
The East and Southeast Asian countries, starting with Japan decades ago, realised that the path to rapid growth was to maintain an undervalued exchange rate and direct credit and other resources to export industries, allowing them to run large balance of payment surpluses that were then invested in US dollars. Export-led growth enabled industries to take advantage of reduced unit costs from large scale production, maintain quality demanded by foreign buyers, and result in large profits for the exporters that would be reinvested in the economy.
The three factors that overcome the principal problems inhibiting rapid development were large markets, avoiding quality-based competition, and mobilising and allocating savings. The banking system readily fell in line behind this strategy. If the currency showed signs of getting too strong, the central bank would buy dollars, thereby increasing the supply and reducing the value of the domestic currency -- undervaluing it.
It worked! Witness the transformation of those Asian economies that followed this path. It is hard to exaggerate what has happened in Asia in the past fifty years, and is continuing in India, China, and Vietnam today. Those economies, like the Philippines and Bangladesh, that rejected this approach, are being left behind.
This approach had little to do with the textbook prescriptions for growth. The textbook story is that poor countries would borrow money from the rich (or receive it in grants), invest the money and thus raise their income. These economies would run a current account deficit (imports of goods and services greater them exports) covered by the inflow of resources from abroad. Organisations like the World Bank, ADB and aid organisations in almost every industrialised country were set up to facilitate this transfer of resources to poor Asian countries on favourable terms. In addition to this flow of resources from rich to poor, the approaches to economic development emphasised private sector-determined credit allocations according to market conditions, low levels of protection, no special assistance to firms (level playing fields), private sector competition, and no intervention in foreign exchange markets.
Some version of this doctrine has come to be called the "Washington Consensus" as it reflected the world view of the US Treasury, the IMF, and the World Bank. When flexible exchange rates were introduced, the policy was for true floating and letting the market determine the exchange rate. In this world there is no real need for foreign exchange reserves, and capital flows are determined solely by private sector decisions. Central banks could hold some foreign exchange reserves but there is no need to do so, other than having a prudent amount to facilitate market disruptions.
South Asian countries followed a program of protecting their industries and overvaluing their exchange rates; while not exactly the Washington Consensus, this is closer to it than what was going on in the rest of Asia! East Asia and most of Southeast Asia simply ignored the Washington Consensus and the textbook story resulting in slow export growth, vicious quality-based competition, slow economic growth, inability to raise domestic savings, and inability to take advantage of economies of scale. This approach led to regular balance of payments problems; the solutionto these was perceived as more capital inflows and greater production for domestic use by increased protection.
The textbooks said there should be no balance of payments problems with the floating exchange rate; however, the East Asian countries set out to export capital to the rich and the South Asian countries set out to import capital from the rich.
The result? There was rapid growth of East and Southeast Asian countries, building up large foreign exchange reserves and maintaining undervalued currencies. The South Asian nations grew slowly, faced constant problems with their balance of payments, and ended up with large debts.
The East Asian countries
In the past few years the East Asian countries have aggressively followed the policy of undervaluation of their currencies, accumulating large foreign exchange reserves, and trying with some success to promote their exports. The measure of this is the increase of their foreign exchange reserves.
During the four-year period from October 2003 to October 2007 the Asian countries increased their reserve holdings by $1.1 trillion! Only four countries -- China, Japan, India and Korea -- accounted for more than 85% of this. If these countries had allowed their currencies to float, all would have substantially revalued in order to reduce the foreign reserve accumulation to zero and their growth would have been much reduced.
This strategy for rapid development, let's call it the "Toyko Consensus," is to maintain a very high savings rate, to maintain an investment rate less than the savings rate, and to ship the difference abroad, largely to the United States by holding US government securities. The weak currencies with low prices in dollars induced the western countries, particularly the United States, to import large volumes of production from the Asian countries. There are two surpluses that must be handled: One surplus is that of savings over investment. The extra savings have to be put to work somehow or the economy will go into recession. These Keynesian effects are very real: if there is not sufficient demand then there will unemployment and slow or negative economic growth. The second surplus is in the balance of payments. Some countries have to be willing to use the savings to demand the real goods and services being exported. These two surpluses are the so-called "imbalances" in the world economy. During the past decade these imbalances have grown and loomed over the world economy with no clear idea as to how these would be resolved, if they would be resolved, or even if they needed to be resolved!
The American economy
The resolution of these imbalances was found in the American economy. There are three large parts of the world economy: The United States, the EU, and Japan. Japan, of course, was part of the surplus group trying to transfer capital somewhere else. The EU has had two characteristics: first, its financial systems are much less aggressive at lending money to households than is the United States financial system. Second, the deficits in most EU countries are limited according to agreement, so that it is difficult for any member of the EU to run a large government deficit for a protracted period of time. For the members of the euro bloc this was considered essential, otherwise a country would increase its government deficit and the rest of the euro bloc would effectively pay for this.
Also, the EU members' government debt markets are not as deep as those of the United States, and habits of central banks die hard as the United States currency has long held the key position in international trade. The EU could not absorb the extra savings of the Asian countries. What would be done with the funds? The corporations had what they needed. The governments could not issue more debt due to agreements among members of the euro bloc. Households did not readily expand their borrowing both from habit and attitudes in the financial system. Hence it was difficult to expand real demands from households or government.
But the United States was something else. Most of the capital was parked in the US government securities as the safest investment around. Now the US government began to run very large deficits by reducing taxes on the rich and going to war in Iraq and Afghanistan. Thesupply of funds from the Asian nations was a convenient way to finance the deficits. But this was not enough -- the households had to be persuaded to borrow and spend. This was done by handing out credit cards to one and all. Then automobile financing was made very cheap so the demand for automobiles increased. The access to loans for housing was made much simpler. More and more people were able to buy houses. In the boom in the housing market, the access to financing led to rising demand, resulting in the price of houses increasing. This then allowed people to borrow on the increase of the house price.
Suppose I purchased a house for $100,000 and had taken a mortgage of $80,000; the value of the house rose to $160,000. I could easily then go and borrow $50,000 as a "home equity" loan as the value of the house now exceeded the amount that I had previously borrowed. Money is flying everywhere. The Asian countries save and send the money to the US; the US government and financial system manage to get these funds invested in purchase of real goods and services. Lending for education went up and with easier credit the universities driven by hungry professors who wanted raised fees and innocent students borrowed. This broad-based expansion of credit was necessary to shift the Asian savings into real demands. It worked.
Of course there was a lot of fraudulent behaviour within the financial system in the United States. The financial institutions faced the immediate problem of lending the money and so caution was forgotten. Insufficient regulatory action allowed this fraud to be far greater than it should have been, but the underlying drive to expand credit available to American households would have continued.
In the United States, the households and the government began to run deficits covered by the incoming funds from Asia. The balance of payments ran a big deficit reflecting the purchase of Asian goods and the inflow of Asian capital. The Asian central banks did not really care about the interest rates they were receiving so the interest rates in the US were low. Actually it had to be that way; the United States did not really need this inflow of funds so to make it acceptable the interest rate had to be low. The low interest rates in the US were an essential part of the increase of credit.
All of these things fitted together. The Asians saved and worked. The Americans borrowed and consumed. Everyone was more or less content with this. The Asian economies grew rapidly, except for Japan having difficulties in increasing aggregate demand in the absence of rapid export growth. This was gradually overcome during the decade with exports organised indirectly -- i.e. sent from other Asian countries to China and then on to the USA after assembly in China.
Put another way, the Asian economies wanted to shift a certain amount of capital to the United States largely through the central banks to US government securities. This meant that the capital account of the United States balance of payments was in surplus -- i.e. more money coming in than going out. Thus the US current account must be in deficit by the same amount. The dollar adjusts to insure that the current account is in deficit. During the past few months the dollar has weakened somewhat. This suggests that the transfer of funds into the United States has slowed or been reduced. It is a mystery at the moment how the weakening of the dollar isgoing to affect the overall situation. The weakening dollar is helping American exports and raising import prices; the weakening in import demand in the United States is more linked to the slowing economy than the change in the exchange rate.
By 2007 the housing boom in the US reached its limits; defaults began as housing contracts raised interest rates. The housing sector experienced reduced demand and this began to trigger a slow down in the American economy as the construction sector contracted. The defaulting housing loans triggered major problems in the financial sector. That is a story for another day. The slowdown in US economy has not yet really spread to the rest of the world -- but it will. The financial crisis excites the banks but the real economy is the major problem.
In addition to the sustained growth of the world economy and the interlocking macro-economic policies of the Asian countries and the United States, the world oil price has begun to rise rapidly. This has created a large balance of payments surplus among the oil producers. This group led by Russia, Saudi Arabia, and Algeria increased their reserves almost $400 billion from October 2003 to October 2007. Thus altogether during that four year period, the reserves of the Asian and petroleum producers rose $1.6 trillion and most of this was deposited in the United States.
What does the future hold?
Is the basic arrangement of the world economy going to change? Perhaps this will indeed happen if the United States becomes more protectionist in its economic policies. However, even though such a change in outlook may take place over the next decade, if the world economy is going to continue to grow and the industrial countries are to maintain the employment levels of the past five years in the near term, it is necessary to preserve the imbalances.
Slowing growth of the world economy is a disaster for everyone -- it will increase unemployment in the industrial countries and slow the reduction of poverty in the developing nations. The rapid growth of the world economy of the past several years was based on the equilibrium discussed above. No one knows what a better alternative equilibrium is.
The most likely outcome is a return to the imbalances with the US running a very large current account deficit and a large inflow of funds into its economy from the Asian central banks and other official entities. Sovereign wealth funds may shift some of the investment into other assets (building, shares etc.) but it does not change the problem of making use of the saving; it is just that the current owners of the real assets will have a lot of money to invest after they sell to the sovereign wealth funds!
How will the United States absorb these funds? Perhaps the only choice is for the United States government to increase its deficit and deal with the real needs of the American people. This includes rebuilding infrastructure, improving health care and education systems, transferring more purchasing power to the poor and retired households, and rebuilding the United States military.
The costs of these are very large, and borrowing is the only way that these can be achieved. American households are already loaded with debt and cannot really take any more. With the large amount of foreign saving the interest rates will not increase so the cost to the US government will be moderate.
If the United States does not increase its deficit to absorb the money then the world economy will fall into a deep and painful recession. The excess savings will be removed by a decline in saving associated with lower incomes! It is unlikely that the demands in the Asian countries will shift to higher consumption; while investment is already very high and does not offer a path to higher internal demand. However, the experience of the past fifty years is that Asian households will save and it is very difficult to change this behaviour. Over the next fifty years of course this behaviour will change, but not over the next five or ten.
There will be a lot of concern expressed that the fundamental imbalances and potential stresses of the world economy are not being addressed. But there seems to be no alternative except more of the same. Perhaps the United States will not run the government deficit required and the world economy will plunge into worldwide weakness.
But my judgment is that the political forces in the United States will lead to acceptance of the need for a greater deficit. The political alignments will not permit significant increases in taxes; there may be a redistribution with higher taxes for the rich and lower for the poor, but it is out of the question that taxes will be significantly increased in the United States. On the other hand there are pressing problems requiring government expenditures that Americans believe have to be solved.
For Bangladesh, a rising world economy is very important to provide the demands for exports and also the sources of foreign investment that are needed to accelerate economic growth. The bad part of this is high prices for energy and food will continue although the increase will slow down. Under my forecast, the flows of capital into the United States for real expenditures will increase, the dollar will become strong again to increase the current account deficit, and the pressure on oil prices will ease.
Forrest Cookson is a Forum contributor.