WORLD ECONOMY DILEMMA

Reported in the FT: Forecasts in the OECD’s latest Economic Outlook imply that in 6 of its members (the Netherlands, Switzerland, Sweden, Japan, the UK and Ireland) the private sector will this year run a surplus of income over spending greater than 10% ratio to GDP. Another 13 will have private surpluses between 5% and 10%. The latter includes the USA, with 7.3%/GDP. The eurozone private surplus will be 6.7%ratio to GDP and that of the OECD as a whole 7.4%. In the USA, In the eurozone, it is forecast at 5.5%/GDP and in the OECD at 7.3%. Actually this is also a product of private savings rising as the counterpart to public sector higher borrowing, after change in the external account balance.
Moreover, the shift in the private sector balance between 2007 and 2010 is forecast to be 9.7% in USA, and exceed 10%/GDP in no fewer than 8 OECD member countries. It is also forecast to exceed 5%/GDP in another 8. Martin Wolf commenting on this says, "Depression threatened. Note that such huge shifts towards frugality will have occurred, despite the unprecedented monetary loosening. While the latter helped prevent a still-greater collapse in private spending, the huge fiscal deficits, largely the result of automatic stabilisers, have been no less important. If governments had tried to close fiscal deficits, as they attempted to do in the 1930s, we would be in another Great Depression."
Wolf then asks, "So how do we exit? To answer the question, we need to agree on how we entered. A big part of the answer is that a series of bubbles helped keep the world economy driving forward over the past three decades. Behind these, however, lay a credit super-bubble, which burst in 2008. This is why private spending imploded and fiscal deficits exploded."
I explain what he means by the bubbles in terms of credit boom growth later below.
Wolf continues, "Now, after the implosion, we witness the extraordinary rescue efforts. So what happens next? We can identify two alternatives: success and failure.
By “success”, I mean reignition of the credit engine in high-income deficit countries. So private sector spending surges anew, fiscal deficits shrink and the economy appears to being going back to normal, at last. By “failure” I mean that the deleveraging continues, private spending fails to pick up with any real vigour and fiscal deficits remain far bigger, for far longer, than almost anybody now dares to imagine. This would be post-bubble Japan on a far wider scale. Unhappily, the result of what I call success would probably be a still bigger financial crisis in future, while the results of what I call failure would be that the fiscal rope would run out, even though reaching the end might take longer than worrywarts fear. Yet the big point is that either outcome ultimately leads us to a sovereign debt crisis. This, in turn, would surely result in defaults, probably via inflation. In essence, stretched balance sheets threaten mass private sector bankruptcy and a depression, or sovereign bankruptcy and inflation, or some combination of the two. I can envisage two ways by which the world might grow out of its debt overhangs without such a collapse: a surge in private and public investment in the deficit countries or a surge in demand from the emerging countries. Under the former, higher future income would make today’s borrowing sustainable. Under the latter, the savings generated by the deleveraging private sectors of deficit countries would flow naturally into increased investment in emerging countries."
Martin Wolf recognised and repeats here what Lord Turner at the FSA and others, but not all, know that the credit crunch has its origins in extreme world trade imbalances that developed in the past decade, extreme differences between credit boom (CB) growth economies (that he calls deficit countries) and export-led (EL) growth economies (that he calls high-income countries).
In CB economies (USA above all, also UK, Spain, Ireland, Greece etc.) increasingly the trade deficit was financed by banks selling asset backed securities directly and indirectly to the EL economies (Germany, Japan, China etc.). The CBs grew by boosting domestic consumption and housing wealth thereby drawing in more and more net imports, while the ELs grew by exports and by capital investment (especially in China's case).
The world, and within it the EU, was polarised by two growth policy extremes, between CBs with a rampant internal growth impulse and ELs profiting from CBs by remaining heavily baised to external growth impulse; everyone else can be placed in a mixed continuum somewhere in between.
Martin points to the dilemma we face now. This reduces to how to avoid simply returning everything to how it previously was? He suggests we do this by CBs investing more and ELs consuming more. The CBs and ELs have to shift, or even reverse, their stances, essentially to rejoin the rest of the world in a mixed policy of trying to balance external and internal growth.
For die hard monetary policy managers, I'm sorry for them if they find such an explanation with its focus on external account and trade too much like Keynesiansm of the past, unpalatable, deeply unfashionable for their modernist technocratic-monetary taste. Martin ends by saying China must boost its consumption. It tried last year and has taken fright because the credit liberalisation went to boost infrastructure and capital investment further which is it knows and recognises already structurally far to high a % of GDP. The country’s banking regulator has told lenders to cut back on credit, especially non-recourse loans to local governments’ financial arms in an attempt to reduce future bad loans. China remains reluctant to boost wages and give up (not until it knows it absolutely must) its low-wage cost competitiveness. It is hooked on economic good news as its main global brand image, like a cocaine addict, desperately unwilling to look at the truth behind the advertised facts that might necessitate revising its economic size downwards by at least 40%! Yet, even with its large population, how it expects to become genuinely the world's second biggest economy with wages at $6,000 beggars understanding.
China, in pursuit of its healthy aspirations to lead the BRICS and join the OECD country club, should enforce its 40-hour week legislation and encourage its population to aspire to more leisure and a higher quality of life. But, the same is also true of highly developed EL economies, Germany and Japan. They need to do far more to actively examine their own internal barriers to higher consumption and internal job creation.
The CBs are far less averse to changing their growth stance that the ELs with their classic conservatism of why do anything different when I have plenty of money lying in the bank?
We may have to wait for China to experience an almighty asset bubble burst and then for the German-led Euro Area's regular recession bus to arrive in about 2 year's from now.
What will shake Japan out of its tree should not be yet more loss of self-confidence, but a recognition that it is time to take its profits and spend that domestically to give its hard-working people the reward of a decade or so of a good time. Of course, the USA tried in vain saying that to Japan for decades without response, and no doubt that is the model that inspires China.
Wolf points to further implications, "Yet exploiting such opportunities would involve radical rethinking. In countries like the UK and US, there would be high fiscal deficits over an extended period, but also a matching willingness to promote investment. Meanwhile, high-income countries would have to engage urgently with emerging countries, to discuss reforms to global finance aimed at facilitating a sustained net flow of funds from the former to the latter. Unfortunately, nobody is seized of such a radical post-crisis agenda. Most people hope, instead, that the world will go back to being the way it was. It will not and should not. The essential ingredient of a successful exit is, instead, to use the huge surpluses of the private sector to fund higher investment, both public and private, across the world. China alone needs higher consumption. Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead."

GREEK CRISIS

Leaving aside questions of how big the black market and smuggling is in Greece, or whether it has used several questionable techniques for disguising the country's true GDP/GNP, debt and deficit, or the passionate left/right politics, Greece is being singled out as the comparative example within the EU whereby the other states may feel only relatively virtuous. What did the country's economy really do and what was the cost benefit to it of Euro membership? Greece's Prime Minister warned his country’s debt woes are a ‘European problem’. But he issued a plea for EU help as deeper-pocketed nations led by Germany continued to wrangle over what kind of rescue is appropriate. Spain, Ireland and Portugal are thought to be most vulnerable to a loss of confidence among investors as they grapple with massive debt mountains. Spain is the most worrying case given the size of its economy. Economists at BNP Paribas estimate that bailout costs of Europe’s fiscal crisis could be £280bn, of which nearly £175bn is attributable to Spain. In Greece's case the requirement is only a few tens of €billions.PM Papandreou says, ‘We are a country which cannot alone deal with the speculation. So this has become a European problem, because if we do have a major problem, this could create a contagion for other countries too who are not to blame,' which is putting the matter kindly. There are some domestic policy problems. Germany’s Finance Ministry yesterday says it has no specific plans to help Greece after a magazine claimed eurozone governments may offer £22bn of financial aid. In fact, that much they have already supplied. It is a test for the flexibility and integrity of the Euro Area idea. It is also a domestic political test in a country, and Athens especially, where political protests are a well-honed art form. Greece has a massive shipping sector, biggest port in the Medittaranean, valuable tourism, and reliable agricultural exports, but not enough to balance the external account at a tolerable level. These and other productive industry sectors did not grow their borrowing or were denied loans by the Hellenic banks that were obsessed like banks in UK, USA, Spain, and Ireland with mortgage boom, but also growing their banking networks in Turkey and the Balkans.
In Greece's case, fast growth in home ownership was a new and novel experience, especially exciting for the economy, part of its catch-up with the aggregate average of the EU. Greece has been much transformed for the better by its decade of fast credit-boom growth. It embraced credit-boom, but the external trade deficit rose to 18% ratio to GDP, the highest in the OECD. This would not have been possible without Euro membership that secured it from currency risk, but could not help it to balance its external account better. Yet, for most of the last decade the economy felt very positive.
Doom-monger economists like myself and real banking experts recognised the boom must eventually end and the property bubble would burst - as it did, if later than for UK and USA, and 90% of bank capital, as I predicted in 2006 for 2009-2012 for several banks including the Central Bank, would be nominally wiped out - at least until debt recoveries and economic recovery would restore matters. Warnings and advice to restructure lending by the Bank of Greece in 2006 and 2007 to the commercial banks were ignored. The banks securitised a fifth of their loanbooks, grew their funding gaps, just like banks elsewhere were doing, and thereby financed the trade deficit to worsen, and grew their property lending gloriously, just like Ireland. And like Ireland, while recognising the perilousness of the situation Greece expected the Euro Area economy would take care of them and the Euro Area economy would bounce back. The ECB did not, however, prove as flexible and as resolute as The Bank of England and The Federal Reserve in scaling up to deal directly with the Credit crunch.
The Euro Area's members like Greece and Ireland that had for some years been the fastest growing and much above average contributors to general Euro Area growth might have felt they had the right to special temporary emergency help when the crisis hit them - a false hope. One intersting difference surprisingly between Ireland and Greece is that the problems of Greece not Ireland were able to knock 50 points off the S&P 500!
What Greece like Ireland under-estimated was the implication of their central banks not having access to their own money market facilities, which had been given over to the ECB. This has meant that unlike UK and USA, bank bailouts had to be negotatiated with ECB or paid for by special loans from EU/ECB or paid for on-budget by bond issuance - most painful in Maastricht terms. It is the fact of having to resort to on-budget bond issuance that makes the deficit and debt ratios especially high, but as sanguine realists have commented, this is a small and temporary problem in the wider scheme of EU-wide economic concerns.
The Bank of Greece had before the crisis advised its member banks to lend more to help exporters and reduce the share of their loanbooks dominated by property. This remains urgently important advice. We must hope that the Greek banks take this advice seriously and now act upon it.