«If the big creditors insist on continuing to run surpluses, this downturn will become deeper and longer than it otherwise would», says Robert Madsen from the MIT
There’s a big responsibility from the countries with liquidity – they are the main engine that can reverse the present severe depression. They have to fuel demand. America is no more the engine of growth. “Returning the global economy to long-term health will require finding new sources of demand. This cannot reasonably be the United States, where consumers are already overstretched and scared; and ultimately it cannot be governments, since national debts cannot rise indefinitely. The answer has to lie in greater spending in the developing world as well as in China, Japan, and Germany.”
– “Deleveraging events are much rarer and more serious, leading in some cases to depressions as well as to bad recessions. In this sense, the early stages of the 1930s Great Depression and Japan’s Lost Decade resemble what has happened globally over the last year. All three were driven by the sudden determination of numerous borrowers to reduce their leverage by a large margin.”
– “American spending was the major engine of global growth.”
– “In summary, the effect of the current deleveraging will make this commercial downturn a deep and long one that in some parts of the world may resemble a depression.”
– “But who holds the leverage right now? Can China pull its dollars out of the US markets without losing vast sums of wealth as American bond prices fall?”
– “The Chinese emergence as a globally important source of credit is important and may well herald a change in the balance of power, but I don’t think that will happen soon. For the duration of the present crisis, at least, excess credit is a weakness and not the advantage it has historically been.”
– “I don’t think Japan did as badly as most people think. It had excess savings and hence excess supply for a very long time.”
– “The answer has to lie in greater spending in the developing world as well as in China, Japan, and Germany.”
– “I do not, however, think that governments are stupid enough to reprise the protectionism of the Interwar Years.”
INTERVIEW by Jorge Nascimento Rodrigues
Q: What were the roots of the present economic depression in the OECD countries: a) the credit crunch engineered by stressed and zombie banks, or b) the crash in stocks and in the house sector shortening liquidity of institutional and private wealthy investors and reducing purchase power from households? Or both are converging for a complex situation?
A: Both factors are responsible, as is a third: the loss of global demand.
a. A typical recession occurs when the private economy overheats and the monetary authorities tighten policy in order to slow things down. Corporations cut back their output, investment, and employment until inflationary pressures abate. At that point the central bank eases monetary policy again and allows commerce to accelerate. The whole process typically takes two-to-four quarters.
b. Deleveraging events are much rarer and more serious, leading in some cases to depressions as well as to bad recessions. They begin when the level of debt in an economy rises far above the normal level, often in a way that causes asset prices to rise dramatically. Then something happens that convinces borrowers-corporations, banks, households, or some combination of them-that they are dangerously indebted and need to pay down much of their obligations. The paying down of that debt through sales of stocks, bonds and real estate even as banks curtail the supply of credit, depresses wealth and, through tighter credit, corporate and household commerce. In this sense, the early stages of the 1930s Great Depression and Japan’s Lost Decade resemble what has happened globally over the last year. All three were driven by the sudden determination of numerous borrowers to reduce their leverage by a large margin.
c. In more detail, over the last fifteen years global leverage (not just the United States, not just banks but also hedge funds and consumer finance companies) rose dramatically. The result was a massive global bubble with pockets of particular excess in a few of the most liberalized real estate markets. Once the subprime market collapsed in the United States, financial institutions in North America and Europe realized they were overextended and started calling in loans and selling assets. One effect was an intense credit crunch, some of whose effects have been mitigated by aggressive central bank action-though the ECB in particular has not done enough in this regard.
d. Meanwhile the asset sales by deleveraging financial institutions started driving down the values of all assets, including stocks and real estate that was not at all subprime. The massive erosion of wealth hurt all investors, corporate and private, with the partial exception of governments that were invested in US or Japanese government bonds. Thus the two factors that you adduced in your question-credit crunch and lost wealth–are different aspects of the same story.
As is a third factor, I would add.
Q: A third factor?
A: The third factor-the one which makes this episode of deleveraging particularly nasty–is its effect on the global imbalances. Over the last decade the United States and a few other countries provided the demand that the world needed, on the margin, to grow. This was financed by people and companies within those economies borrowing against the bubbles in real estate and securities markets. It is tempting to view the global imbalances as a result of this excess spending and the current account deficits it produced. But there is another way of looking at the problem. In fact, the extra demand produced in the US, the UK and some other countries was critical to the world because so many other countries-Japan, China, Germany, the developing world, the oil exporters-were all saving much more than they ideally would have done and needed to import demand to keep their economies growing. The overreliance on US consumption was thus the reflection of excess savings elsewhere. American spending was the major engine of global growth.
Q: In that context, what was the impact of the deleveraging process?
A: The deleveraging process would have been difficult enough if it had occurred alone, but its effect on American consumption complicated the problem badly. The sharp loss of US spending means that other countries have lost much of their export markets and will inevitably see their growth rates decline significantly. Unless consumption suddenly increases in the creditor nations (Japan, China, the developing world, Germany) or the US consumer starts spending irresponsibly again-which is unlikely given the lack of credit-the result will be a sustained deceleration in global growth. Instead of expanding at 5-6% per annum as in 2005-2006 over the next decade, it may grow at just 3.0-3.5% for several years. This is unfortunate not only because it means living standards will not rise as fast but also because it may not be enough to suppress unemployment rates in much of the world. Thus we could have several countries around the world shrink by close to 10% of GDP this year and others enter a protracted period of unemployment at 10% or more-both of which meet alternative definitions of depression. In summary, the effect of the current deleveraging will make this commercial downturn a deep and long one that in some parts of the world may resemble a depression.
Q: The present crisis in the US and in the other OECD countries is “lighter” or worse than the Japanese one of the 1990s?
A: The Great Depression, Japan’s 1990s malaise, and the current debacle all originated in the collapse of bubbles and the ensuing process of aggressive deleverage. Japan’s challenges were aggravated, however, by the ageing of the country’s population, which meant a sustained deficit in consumption (alternatively, elevated savings) and a shrinking labor force for something approaching two decades. In this sense Japan’s stagnation was more firmly entrenched than what happened in the Great Depression or the present global crisis. But the country also benefited from a strong external environment: it was growth in the US and China that caused Japan’s current account surplus to expand, kept its factories busy, and allowed GDP to increase rapidly from 2002 to 2007. Now that that external support has collapsed, so too has Japan’s economy. The world should do better than Japan did, since it does not face the same demographic problem. There will be demand from the developing countries and from some parts of the OECD world, which should enable the rate of worldwide growth to increase after 2010 to 3% or a bit more. There are, however, downside risks: governments could make mistakes, as they did in the 1930s, and consumers in the big creditor nations remain insecure and consequently fail to expand their spending. This would depress the medium-term growth rate a bit further.
Q: It’s difficult to compare Japan of the 1990s with US or some of the European countries of today (probably excluding Germany, another powerhouse of exports). Japan was and is a powerful creditor, unlike US and the Europeans, most of them addicted debtors. So, probably, it’s difficult to extract lessons from Japan for the US and Europe, or not?
A: I think it is a mistake to treat creditor nations as if they are stronger than debtor nations. Creditors look strong if you believe that debt is the problem; excessive consumers look strong if you perceive chronically inadequate demand as the systemic vulnerability. You are right in saying that Germany, Japan and China used to comprise a separate category from the profligate economies like the United States. But the loss of the American consumer has created a global situation that looks a lot like 1990s Japan. Japan lacked adequate demand and was forced to grow through a combination of greater current account surpluses and government spending. The world today is in danger of inadequate demand and, since it can’t export to other planets, has no choice but to expand government spending dramatically until private demand begins to resume somewhere. So the world can learn a lot from 1990s Japan even if the United States, still with excess demand, looks somewhat distinct.
Q: But in geopolitical terms to be a creditor is not an advantage that could be leveraged? We can remember the relationship between the US and the British in the 1940s.
A: Yes, you are right. But who holds the leverage right now? Can China pull its dollars out of the US markets without losing vast sums of wealth as American bond prices fall? Then would come higher bond yields, less investment and consumption within the United States and much weaker demand for foreign goods and services. The world recession would deepen and lengthen, and China’s growth rate would fall. It might be appropriate to recall the old banker’s saying: “if you owe the bank $100, you are in trouble. But if you owe the bank $1 million, it is the bank that is in trouble.”
Q: But there’s a moment when the creditor, even if loosing in the financial side, will act upon the debtor, particularly if it is dealing with the incumbent superpower…
A: I think we are talking about two different things, or at least two different timeframes. Over the longer term China may be able to use its creditor status to displace the United States, but in short term China desperately needs American demand. You’ve probably noticed that over the last week (May 18-22) or so China has distanced itself from the idea of fleeing the dollar, saying fos instance that it will continue to finance the US debt. This is not altruism, but a statement of chinese necessity.
Q: For sure China will act with intelligence and in the long term. The US managed the relationship with the UK from the 1910s till the 1940s…
A: There are also a couple of other complicating factors. One is that a dominant currency has to meet other preconditions besides being based on a massive suplly of credit. One of these is a clearly dominant economy, which China does not yet have. Another is convertibility, which is largely impaired in the case of the renmimbi. Still another is stable and internationally compatible governance, which Beijing again does not yet have. Another factor that accelerated the US displacement of Great Britain was of course the devastion of two world wars. In the absence of such events the transition would have taken decades more.
Q: So, the time has not come yet for China…?
A: The Chinese emergence as a globally important source of credit is important and may well herald a change in the balance of power, but I don’t think that will happen soon – and it almost certainly cannot until the world has found a sustainable alternative to US demand. For the duration of the present crisis, at least, excess credit is a weakness and not the advantage it has historically been.
Q: What was the main policy error from the Japanese between the “Akio Morita shock” in 1991 and the temporary recovery of 2002?
A: I may surprise you, but I don’t think Japan did as badly as most people think. It had excess savings and hence excess supply for a very long time. Singapore, Switzerland and other countries with this problem have run current account surpluses of about a tenth of GDP during these times and no one has complained. Japan was much bigger, so the export of so much capital would have hurt the rest of the world-more deflationary pressure-but, ironically, China has been allowed to do much the same thing. So part of the story is why the world has been so much more patient with China. Domestically, it is hard to see how Japan could have pushed down its savings rate. Structural reforms of the sort that increase supply and lower prices might have made things worse, though that is what the US and other foreign powers demanded of Tokyo. Absent that success, expanding the government deficit to keep GDP growing was a good policy. By default, the rest of the world will now do the same thing. The only alternative, globally and within Japan, would be to encourage consumption to expand sharply-which is empirically difficult to do.
Q: So, Japan´s lost decade was not so “lost” after all? There’s certain hype in the criticism from the West analysts?
A: Japan made lots of errors. It should have been much more aggressive with monetary policy, should have avoided the tax hikes of 1996-7, etc. But given the huge problem of excess savings and inadequate demand, it could easily have undergone a depression. Avoiding that was a significant accomplishment, one that outsiders often underestimate.
Q: You say “ironically, China has been allowed to do much the same thing [as Japan]. So part of the story is why the world has been so much more patient with China. “. Why it happened?
A: That is a very interesting question and I don’t have a completely satisfactory answer. In part, it is probably because China is perceived as being a small economy even though that is no longer the case. Another factor is that the Chinese surplus widened rapidly at a time of fast worldwide GDP growth, when countries were less worried and more tolerant. The middle 1980s, when Japan’s imbalance became problematic may have been a more anxious time with memories of the Reagan recession still fresh. Perhaps politicians were more sensitive then. But politics must surely be part of the story as well. Japan relies on the US and has been in a constant dialogue with it. China is an outsider whom the West would like to draw in. I think that reality translated into more tolerance regarding any number of Chinese policies, from human rights to support for nasty governments around the world and perhaps even to economic policy.
Q: The geopolitical and geo-economic situation is today very different from that of the 1990s when Japan began its “lost decade”. Now we have a group of big world creditors with liquidity and with a geopolitical strategy like China, Brazil, India, and the petro-Arab SWF. How this new situation will impact in the evolution of the present Depression?
A: If the big creditors insist on continuing to run surpluses, this downturn will become deeper and longer than it otherwise would. Ultimately developing countries must become a net source of demand. My feeling is that they will not do this until they are convinced that the IMF or some other organization will help them in times of trouble, thereby obviating the need for precautionary current account surpluses.
Q: Are you expecting a balkanization of the global trading system? What will be the most challenging task for the WTO in the months and years ahead?
A: I exaggerated a bit when I used the word “Balkanization.” [referred at an article at Foreign Affairs magazine]. We are already seeing fiscal stimulus packages that favor domestic interests and discourage international cooperation, and the bank recapitalization efforts have the same effect. So to some extent the global system is weakening somewhat. I do not, however, think that governments are stupid enough to reprise the protectionism of the Interwar Years.
Q: Can we compare the ongoing Depression with the Great Depression of the 1930s? If there’s a public policy “lesson” for nowadays from those Great Depressions, which would be?
A: This downturn could border on a depression in some parts of the world though it will not approach the scale of the 1930s Great Depression. Monetary and fiscal stimulus are so much better understood, and used, now than in the past. The lessons that one could glean, however, include:
a. Countries that depreciate dramatically and early fare better than those that hold their exchange rates constant. Obviously this is a difficult game, but empirically the observation is factual;
b. Monetary and fiscal stimulus must be aggressive, so too bank recapitalization;
c. The late 20th-century preoccupation with excess demand and inflation may no longer be appropriate. In deflationary times, the weakness is inadequate demand. Returning the global economy to long-term health will require finding new sources of demand. This cannot reasonably be the United States, where consumers are already overstretched and scared; and ultimately it cannot be governments, since national debts cannot rise indefinitely. The answer has to lie in greater spending in the developing world as well as in China, Japan, and Germany.