By Martin Wolf
Published: January 20 2009 20:38
(How we got to this point...)
What then is the global failure? It is the malign interaction between some countries’ propensity towards chronic excess supply and other countries’ opposite propensity towards excess demand. This is the theme of my book Fixing Global Finance. But the biggest point about the world economy today is that the credit-fuelled household borrowing that supported the excess demand in deficit countries has come to a sudden stop. Unless this is reversed, excess supply of surplus countries must also collapse. This statement follows as a matter of logic: at world level, supply must equal demand. The question is only how the adjustment occurs.
Michael Pettis of Peking University laid out the argument in the Financial Times on December 14 2008. Professor Pettis sees the world as divided into two economic camps: in one are countries with elastic systems of consumer finance and high consumption; in the other are countries with high savings and investment. The US is the most important example of the former. China is the most significant example of the latter. Spain, the UK and Australia were mini versions of the US; Germany and Japan are mature versions of contemporary China.
I have argued that the driving force behind these “imbalances” has been the policies of surplus countries and particularly of China, whose surpluses have grown particularly quickly . A managed exchange rate, huge accumulations of foreign currency reserves and sterilisation of their monetary consequences, tight fiscal discipline and high retained earnings of companies have generated national savings rates of well over 50 per cent of gross domestic product and current account surpluses of more than 10 per cent. Household savings appear to generate less than a third of total savings. In turn, investment has poured into expanding supply, including of exports: the ratio of China’s exports to GDP rose from 20 per cent of GDP at the beginning of 2002 to 37 per cent in 2007 (see chart).
The view that the excesses of deficit countries were partly a response to the behaviour of surplus countries is shared by a number of policymakers, including Hank Paulson, outgoing US Treasury secretary. Zhang Jianhua of the People’s Bank of China is reported to have declared that “this view is extremely ridiculous and irresponsible and it’s ‘gangster logic’ ”. In this perspective, the pattern of global deficits and surpluses was solely caused by western policymakers, particularly the Federal Reserve’s lax monetary policies and unregulated expansion of credit.
Yet, whoever was most responsible, one point is certain: huge asset price bubbles made possible the excess supply of some countries, particularly China. Since the Asian financial crisis of 1997-98, the developed world – and the US in particular – have experienced, successively, the largest stock market bubble and the biggest credit-fuelled housing bubble in their histories. This era is over. We will struggle with its aftermath for years.
(The current dilemma...)
So what happens now? The implosion of demand from the private sectors of financially enfeebled deficit countries can end in one of two ways, via offsetting increases in demand or via brutal contractions in supply.
If it is going to be through contractions in supply, the surplus countries are particularly at risk, since they depend on the willingness of deficit countries to keep markets open. That was the lesson learnt by the US in the 1930s. Surplus countries enjoy condemning their customers for their profligacy. But when the spending stops, the former are badly hurt. If they try to subsidise their excess supply, in response to falling demand, retaliation seems certain.
Obviously, expansion of demand is much the better solution. The question, though, is where and how? At present much of the expansion is expected to come from the US federal budget. Leave aside the question whether this will work. Even the US cannot run fiscal deficits of 10 per cent of GDP indefinitely. Much of the necessary expansion in global demand must come from surplus countries.
Managing this adjustment is far and away the biggest challenge for the group of 20 advanced and emerging economies, which will meet in London in early April. Mr Obama must take the lead. He can – and should – say he expects these adjustments to be made, but understands they will take time. He can also sustain exceptional fiscal and monetary measures in the short term, if his country’s main trading partners make the necessary medium-term adjustments in their spending. China, in particular, needs to create a consumption-led economy. That is in the interests of China. It is also in the interests of the world.
(The path forward...)
If the world economy is to be less dependent on destructive bubbles, more of the world’s surplus capital needs to flow into investment in emerging economies. The problem, however, is that such flows have also always led to crises. This is why emerging economies set themselves to accumulate vast foreign currency reserves in this decade. It is essential, therefore, to make the world economy much more supportive of net borrowing by emerging economies.
What will be needed for this is far bigger and more effective insurance against systemic risks than the International Monetary Fund now provides. A crucial step is a restructuring of the IMF’s governance, to make it more responsive to the needs of responsible borrowers. One of the ideas Mr Obama should propose is the establishment of a high-level committee to recommend a radical restructuring of global institutions, with a view to lowering risks of the emerging market crises that preceded the era of advanced country bubbles.
Let us be clear about what is at stake. It is essential to clean up the huge current mess. But it is also evident that an open world economy will be unsustainable if it remains dependent on bubbles. Collapse of globalisation is now no small risk. Mr Obama is present at the re-creation of the global economic system. It is a challenge he has to take up.