Financial Daily from THE HINDU group of publications
Tuesday, Feb 19, 2002
Is the world headed for depression again?
C. P. Chandrasekhar
THE talk of possible recession has been in the air internationally for some time now. And of course, after the September 11 attacks on New York and Washington, the US Government, the IMF and others were quick to seize on this as the excuse for predicting a future downturn, which could then be claimed as the adverse fallout of international terrorism.
The truth is of course, that the weakness in the international economy was already well advanced for some time before September 2001. In fact, much of the world economy had actually been experiencing a slowdown or recession for several years before the last quarter of 2001.
In fact, the most striking feature of international economic trends during the 1990s was that the US experienced strong growth while most of the other economies in the world system languished. This was essentially because confidence in the US dollar had made American capital markets a haven for the financial investors. This fed a consumption-led boom within the US, and also caused growing current balance of payments deficits for the US economy. The current account deficit of the US reached the record level of $450 billion by the end of 2001.
These trends made the latter half of the 1990s unique in the history of post-war capitalism for another reason. In the past the country holding the international reserve currency did not face any national budget constraint because it could print money and spend it across the world, since everyone was willing to accept and hold such money. As a result, the government of that country routinely resorted to deficit spending to keep the world economy moving. That is, the US economy played the role of locomotive of world growth by sustaining deficit-financed spending.
According to one estimate (published by Morgan Stanley), the growth in US gross domestic product was responsible for about 40 per cent of the cumulative increase in world GDP in the five years ending in mid-2000, which is twice America's share of the global economy. In this period, demand growth in the US was 4.9 per cent per annum compared to 1.8 per cent in the rest of the world. In other words, US economic expansion pulled the rest of the world behind it, at least to some extent.
That process ended some time in late 2000. And with the US engine of growth slowing down, it meant that other countries which had been relying on the huge demand for their exports from the US to keep their own growth rates positive were adversely affected. This has been immediately evident in terms of world trade. WTO figures suggest that the growth of world trade in volume terms, which was more than 12 per cent in 2000, was only around 2 per cent in 2001. And when this is combined with continued deflation in terms of trading prices in world markets for primary commodities and many manufactured goods, world trade in value terms was stagnant.
Output growth, prices in major economies
The growth patterns in the major developed industrial countries are crucial indicators of the overall pattern of the international economy. Chart 1 provides the IMF's latest estimates and projections of growth of real GDP. It should be noted that these estimates, published in December 2001, are already significantly lower than those published by the IMF just three months earlier. While the IMF has attributed the decline to the September terrorist attacks, it could be argued that the earlier estimates were anyway too optimistic, as many had suggested at the time.
Thus the US economy, which had led in terms of growth rates of more than 4 per cent per annum until 2000, fell to only 1 per cent growth of real GDP in 2001. In fact, other sources suggest even lower growth figures for the US for the past year. Industrial output in particular has been falling for more than a year.
Further, this period of slowing growth has been accompanied by decelerating and, now, even declining price levels, raising a real threat of deflation for the first time since the Great Depression. Chart 2 gives the IMF estimates of changes in consumer prices, which suggest that inflation slowed down sharply and there was deflation in Japan. But other sources point to stronger tendencies towards deflation even in the US economy. Figures from the US Labour Department indicate that while wholesale prices rose by 0.1 per cent in January 2002, they had fallen a cumulative 2.6 per cent in the year to January, which was in fact the biggest 12-month drop in half a century.
Similarly, the data on industrial capacity (only 75 per cent in January 2002), a quarter of which went unused in January, have been argued to reflect strong productivity growth, but they also raise concerns about the risk of deflation a vicious cycle of falling prices, profits, production and employment. Business investment in the US fell by nearly 13 per cent in the last quarter of 2001 compared to the previous year, making it the fourth consecutive quarter of falling investment.
The EU was supposed to be recovering from 2000, but the past year's growth performance was once again lower, suggesting that the earlier growth impetus, such as it was, was not sufficient to raise the dynamism in the European economy. Both the IMF and the OECD estimates suggest a further deterioration in aggregate growth performance of the EU in the coming year.
The Japanese economy is currently in the weakest position of all the major capitalist economies. Clearly this economy is in the grip of a classic deflation, with low output, falling prices and poor expectations leading to declining levels of investment. The Japanese Government's own forecasts show that the economy will not grow at all in the fiscal year starting April, with unemployment continuing to rise, to nearly 6 per cent.
In 2001, prices in Japan fell for the third year in a row, which is unprecedented for a major industrial economy since the 1930s. Furthermore, net export performance has also worsened. There was a 38 per cent fall in the Japanese trade surplus for 2001, the largest fall since 1970 and the third successive year of decline.
Accompanying all this has been a strange process of convergence of unemployment rates, as evident from Chart 3. While Japan had always been considered a low unemployment economy largely for structural reasons, it was argued that more "flexible" labour market combined with greater economic dynamism made rates of open unemployment much lower in the US than in Western Europe. But Chart 3 shows that over the recent past, while rates of unemployment have been declining in Europe (despite less impressive output growth) they have been rising in both the US and Japan.
What is the prognosis, given such a combination of forces in the major economies? Most analysts have been pessimistic about the prospects of an early recovery, despite the Bush administration's efforts to provide a fiscal stimulus through large tax cuts and increased spending, especially after September 11. The pessimism ranges from perceptions that the size of the fiscal stimulus is simply not enough to provide the kind of stimulus which is required, to the argument that it has been largely oriented towards tax cuts for large corporations and the wealthy along with increased military spending, neither of which have large multiplier effects.
Another view is expressed in a report issued in December 2001 by the Levy Economics Institute, written by economists Wynne Godley and Alex Izurieta. They argue that the current recession in the US is different from earlier ones because of large structural imbalances in the US economy. According to them, "The US should now be prepared for one of the deepest and most intractable recessions of the post-World War II period, with no natural process of recovery in sight unless a large and complex orientation of policy occurs both here and in the rest of the world. The grounds for reaching this sombre conclusion are that very large structural imbalances, with unique characteristics, have been allowed to develop. These imbalances were always bound to unravel, and it now looks as though the unraveling is well under way."
In Japan, deflation currently poses the greatest threat. Not only have prices been falling over the past three years, the rate of decline has been accelerating. Falling prices raise the real level of interest, which explains why the very loose monetary policy with historically low nominal interest rates has not implied falling real rates of interest, This is the classic "liquidity trap" situation. High real rates of interest in a depressed real economy increase the debt burden on both the private and public sectors to potentially unsustainable levels. Over the past decade, the ratio of gross public debt to GDP in Japan has increased from 61 per cent to 131 per cent, which is now the highest level for any OECD country. If debt levels keep rising in this manner, it is possible that this may lead to a collapse in public confidence in such debt, which in turn can even lead to an Argentina-like crisis with soaring interest rates, high inflation and outright default.
This means that the attempt to explain the Japanese economic conundrum in terms of a bloated and opaque banking sector completely misses the point, since it is the macroeconomic conditions which are creating the problems in individual banks as well. Certainly it is the case that in an economy that is already burdened with vast post-bubble debt and a heavy burden of non-performing loans held by the banking system, falling prices and consequently rising real interest rates could result in a spiral of mass bankruptcy, financial contraction and deepening recession.
So far the rest of the developed world has tried to ignore the magnitude of the Japanese economic quagmire, and certainly has not provided any meaningful assistance. But there can be significant international implications if the problems get worse, which they seem likely to do at present. Japanese capital has financed a large portion of the US international debt. So an implosion on the Tokyo financial markets, leading to the calling in of funds from the rest of the world, would have major consequences for the world economy. At the very least this would certainly prevent a rapid recovery in US financial markets, but it could have even more devastating financial effects.
Policy choices the fiscal stance
One of the more destructive economic consequences of the downfall of Keynesianism in mainstream policy discussion has been the conscious rejection of the fiscal stance as a major means of changing levels of economic activity. One of the more blatant examples of this has been in the case of the EU, in which the Growth and Stability Pact of the Maastricht Agreement explicitly restricted the ability of member-states to use fiscal deficits to reduce levels of excess capacity and unemployment.
Nevertheless it is true that the conditions for using fiscal policy in this manner have changed significantly over the past decade, partly because of the cross-border mobility of finance, which can play havoc with domestic attempts to reflate economies, and partly because of certain other processes. In fact, what is remarkable about the period since the mid-1990s in particular, is the very different effects that fiscal policy have had on particular economies, often completely contrary to received wisdom.
Consider the evidence presented in Charts 4a to 4d. The first point to note is how the fiscal deficits have been declining quite rapidly as shares of GDP in all the advanced countries taken as a group, to very low levels. In fact, in terms of structural deficit (that is, accounting for the fact that fiscal deficits move with business cycles, increasing in slumps and declining in booms), the fiscal deficit in the major advanced economies was less than 2 per cent of GDP in the latter half of the 1990s and has been less than 1 per cent thereafter.
In the US, the boom was originally led by large increases in government spending combined with tax cuts. In the mid-1990s, however, the US, despite being the country with the international reserve currency, chose to curtail its fiscal deficits initially. And when the US Government was confronted with surpluses in the course of the boom triggered by private spending, it chose to hand over some part of those surpluses to the private sector in the form of tax cuts. As Chart 4b shows, since 1999 the US government budget has been in surplus (negative deficit indicates surplus).
Nevertheless, the US economy continued to surge ahead in growth terms over this period. The demand increase was, therefore, entirely private sector-led, fuelled by debt-driven household consumption increases which were inspired by the capital gains made by those with some direct or indirect investment in stocks and shares. Since the middle of 2000, however, such capital gains have turned negative.
However, fiscal policy has responded by becoming more expansionary only in the very recent past, with expenditure increases of just under $100 billion being announced in the wake of the terror and anthrax attacks. Instead, over most of 2001, official policy has been directed towards a looser monetary policy, with the US Federal Reserve announcing six interest-rate cuts over the course of the year. However, the interest rate cuts alone have done very little to push the economy out of the current recession.
In Europe, the attempts at fiscal compression seem to have gone much further than even the fairly stringent requirements of the Stability and Growth Pact. Both the actual and structural fiscal deficits (shown in Chart 4c) since 1998 have been amazingly low, well below 1.5 per cent of GDP, despite the evident recession and the continuing high level of unemployment. Given the supposed political domination of Social Democratic parties in most of the governments of Euro area countries, this pattern obviously requires greater political economy analysis.
But the most striking pattern is that of the Japanese economy (Chart 4d), in which the fiscal stimulus appears to have been used with much effort but to little effect over the past few years. The Japanese government budget has moved from the modest surpluses which characterised the decade until 1985, to very large deficits amounting in some years to nearly 8 per cent of GDP. These were part of the efforts to pump-prime the system, along with low nominal interest rates that have reached near-zero levels. But still they have not been able to lift the Japanese economy out of the deflationary spiral.
What do these contrasting fiscal patterns and their even more contrasting results suggest? It would be wrong to infer from these that fiscal policy is not an important means of changing levels of economic activity in the advanced capitalist economies. However, these data do suggest that the pattern of fiscal stance, of the kind of spending and taxation decisions that are made, may be even more significant than the absolute levels. Crucially, they are important because they can change levels of employment, and these in turn play an important role in affecting expectations of economic agents in the economy.
Thus, in the US economy, the fiscal stance could be low because the consumption boom was associated with employment growth, which in turn added to higher private spending. Conversely, in Japan the combination of fiscal stimulus and interest rate cuts was not sufficient to reverse the trend of declining employment opportunities. These led to depressed expectations, which in turn meant that additional incomes tended to be saved to insure against future job loss, and therefore did not translate into higher economic activity.
Role of unemployment and employment growth
Clearly, therefore, it is necessary to investigate patterns of employment and unemployment in the major advanced economies more closely. Chart 5 show the unemployment rates (as per cent of labour force) in the OECD economies, and shows how in all the major countries except the US, unemployment rates have tended to increase over the latter part of the 1990s.
However, there are substantial differences in definition and measurement of open unemployment across the OECD, and therefore Chart 6 presents the standardised data which tries to use similar definitions. This presents a rather different picture. Thus, Japanese unemployment rates appear to rise more sharply while European unemployment rates appear to have fallen slightly.
A major problem with such data is the growing presence of the "discouraged worker effect", whereby potential workers and long-term unemployed (especially, but not exclusively, women) tend to drop out of the labour force and therefore disappear from both numerator and denominator. This problem has been evident in Europe for some time, but there are indications that it has been growing in the US as well in recent times. Thus, the slight fall in the unemployment rate in January 2002, from 5.8 per cent to 5.6 per cent, has been widely attributed to the "discouraged worker effect".
Because of this, rates of aggregate employment growth may be a slightly better indicator of labour market conditions than open unemployment rates. Of course, even these do not give us an idea of the nature and quality of employment, as most governments increasingly include a range of part-time and casual employment as well, which may reflect distressed worker involvement. Nevertheless, Chart 7 presents the evidence on rates of employment growth in the major OECD countries.
The picture that emerges is that of fluctuating rates of expansion, but overall a fairly dismal performance.
The other point to note is that the employment expansion of the US economy is not all that impressive in comparative perspective, and has been less than 2 per cent per annum over the past five years on average.
This is confirmed by the rather rough estimates of employment elasticity of aggregate output (per cent change in employment by per cent change in real output) that are provided in Chart 8.
Once again, after the early 1990s, the US economy does not emerge as considerably more dynamic than other OECD countries in terms of generating more employment. (It should be noted, however, that the figure of one for the EU for the period 1990-94 is misleading, for it refers to a period when both output and employment growth were mildly negative.) In fact, in recent years the employment elasticity of output growth in the US economy appears to have been very low.
This points to a major structural weakness of the past growth pattern, which is likely to have important effects on the prospects for early recovery in the developed world.
As long as basic employment conditions do not improve, attempts to generate economic expansion by encouraging private savings and investment such as in the form of tax cuts and easy money through low interest rates are likely to falter. This is because those in employment are likely to guard against the possibility of future job loss by saving more rather than spending more. To counter such a tendency, fiscal packages have to be not only very large but also explicitly directed at job creation. This has not been the case so far in either US or Japan, while in Europe the fiscal stimulus has in any case been weak.
In addition, there are other reasons why it may be futile to expect another US-led boom to bring about a recovery in the world economy once again.
After all, the current recession in the US reflects the collapse of a speculative bubble, and it would be strange if the economy could immediately create another such bubble to generate that kind of economic growth.
At present, the bursting of the bubble involves the corporate sector cutting back investment because of overcapacity and the household sector reducing its consumption because it is already financed by record levels of private debt.
A rapid reversal of these tendencies is not only unlikely, but it would also require additional international financing, with the rest of the world's savings once again rushing in to maintain high levels of US consumption and economic activity.
An increase in US growth levels sufficient to lift the world economy would lead to a further rapid widening of the US balance of payments deficit, which is already at more than 4.5 per cent of GDP. Such a payments gap would in turn require an increased financial inflow from the rest of the world to sustain it.
But the rest of the world already provides nearly $2 billion per day in their savings to the US economy. It is difficult to see how this can be increased in a wider international context of lower income growth and stagnant employment generation.
Clearly, the only feasible solution for international capitalism is concerted expansion, directed by a responsible world "leader" who would behave in a Kindleberger fashion to organise such an expansion.
But the current international political economy suggests that such a solution is not feasible or likely at the moment. Therefore, some sort of world depression does indeed seem likely.
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