Darling, it’s all about the global imbalances

Tinkering with UK tax rates and spending plans won’t solve the economic crisis because the ‘fundamentals’ are not sound.

Stuart Simpson

24th November 2008

On Monday afternoon, the UK chancellor of the exchequer, Alastair Darling, will present his annual pre-budget report to the House of Commons. This event has taken on particular importance this year with the combination of a banking crisis and a mounting recession.

The centrepiece of the government’s proposed fiscal stimulus package is expected to be a reduction in the rate of UK sales tax – value added tax (VAT) – from 17.5 per cent to 15 per cent. The government’s plan is to lend to consumers today the money they will take from consumers tomorrow. For example, alongside tax cuts the package is also expected to contain a commitment to raise income tax for earnings over £150,000 per year to 45 per cent after the next election.

Events of recent weeks have vindicated Darling’s comments in the summer that economic conditions ‘are arguably the worst they’ve been in 60 years’. But the limited nature of the proposed package assumes that we are experiencing a temporary, if serious, economic slowdown. Indeed, a cut in VAT doesn’t even come close to the silent fiscal stimulus package that Labour has pursued over the past decade. A report published in the Financial Times today estimates that two out of three jobs created since 1998 have been financed by public spending, and that growth in the private sector, excluding financial services, has been more sluggish than previously thought.

The growth model of the developed world, which has been reliant to a great extent on cheap credit and government spending, is broken. As yet, there is nothing to replace it. Darling’s assertion that the fundamentals of the economy remain sound is dangerously complacent. The past decade has seen a remarkable period of global economic growth. It is only by understanding the nature of the growth in global production and, importantly, the inability of the developed world to capitalise on this growth, that we can begin to tackle the current economic crisis.

A misplaced blame game

Complex financial products, reckless bankers, greedy housing speculators and lax regulators have all been blamed for the credit crunch. But focusing on these villains distracts us from the serious business of how the global economy is being re-shaped.

Cheap credit has fuelled a huge speculative bubble in housing and many other assets. Blame has been shared widely. Alan Greenspan, the former chairman of the US Federal Reserve, has been singled out as the man who kept US interest rates too low for too long, holding down the cost of credit. Bankers have received considerable blame for recklessly expanding this supply of cheap credit through financial innovations such as mortgage-backed securities. Homeowners have been blamed for borrowing more than they could afford to repay in the hope of cashing in on ever-increasing house prices. By indulging in this blame game, we risk losing sight of important developments in global production that can illuminate the current crisis.

As the world economy has expanded in recent years, imbalances between different regions have become more pronounced. Simply put, America as a nation has been consuming more goods and services than it has been producing and China has been producing more than it has been consuming. The effect this relationship has had on the cost of credit in America, and by extension the rest of the developed world, helps explain how the US could maintain cheap credit, consistent growth and low inflation. China alone has supplied the United States with almost $2,000billion dollars in low-cost debt.

The story of the rise of Asia and the shift of the global economy eastward is a familiar one, producing much alarmed debate about the consequences this will have for the competitiveness of domestic industries in the West and on the international political balance of power. Wall Street institutions have looked to foreign buyers – in particular, the enormous sovereign-wealth funds – to recapitalise US banks. These funds represent a global imbalance between production and consumption. But debate about these imbalances has largely been confined to specialist discussions amongst economists and central bankers.

Global growth moves east

Over recent years sustained, high rates of economic growth have become more widespread throughout the world. The giants of the developing world, China and India along with other east Asian economies, have experienced rapid growth in services and manufacturing. Commodity-exporting regions and countries such as the Middle East, Russia, Venezuela and Angola have all benefited from this expansion in production as they have supplied the fuel for economic growth. Latin America is home not just to oil exporters, but also to other growing economies such as the populous and fast-growing giant Brazil. Even oil-importing, Sub-Saharan African countries, that have stagnated or worse for decades, have posted growth rates topping five per cent per annum.

Commentators have described China’s dramatic growth as a third industrial revolution. But China’s growth is part of a revolution more widespread and more dynamic than the growth of industry in England in the late eighteenth century or the development of mass manufacturing in America a century later. The number of people engaged in producing goods and services for the global economy has doubled in just a few years. Hundreds of millions of people have been raised out of poverty and are on their way to joining the modern world.

The growth of the ‘Asian Tigers’ (initially South Korea, Singapore, Hong Kong and Taiwan but later including Malaysia, Thailand and others), followed by China is hardly a new development. But the cumulative effect of sustained high growth levels is profound. A $10bn economy growing at 10 per cent per annum adds another $1billion of output, but a $100billion economy growing at 10 per cent per annum adds $10billion. Even before the American economy slowed to a standstill recently, China was contributing more to the increase in global growth than the US. However, America still generates a quarter of total global output, four times that of China’s contribution.

While many economies in the developing world have been growing rapidly in recent years, this period has been characterised in the developed world by relatively low rates of growth, although this growth has been stable and consistent. Inflation has been low and major recessions have been avoided. Indeed, some economists divide the twentieth century into the Great Depression, the Great Inflation and, more recently, the Great Moderation.

Asian financial crisis

Moderation hasn’t been the story for much of the developing world. Growth rates in many countries have been much higher than in the developed world, but financial and economic crises have been more common, too. It is the fallout from the last major financial crisis in the developing world that leads to an understanding of the development of the global imbalances that have played an important role in the current credit crunch.

In 1997, a financial crisis spread through east Asia, and countries struggled to meet payments on foreign debt. In the years leading up the crisis, many developing countries in Asia had been borrowing money from the developed world in order to maintain high levels of investment to fuel their rapid economic expansion. Developed economies that were rich in capital had been investing in a region that was poor in capital, but rich in opportunities. Such balance of payment crises have afflicted developing economies for decades.

Investors don’t like lending money in weak currencies, so poor countries usually have to borrow US dollars to finance development and grow out of poverty. That means that if the value of their own currency falls, they have to stump up more of that currency to repay foreign lenders in dollars. The Asian financial crisis was not only a severe and widespread meltdown in the developing world, but it also impacted upon the richest and most successful emerging economies.

South Korea, a country that had suffered decades of war, foreign occupation and military dictatorship, had by 1997 become a wealthy and thriving democracy, joining the developed economies ‘club’, the Organisation for Economic Cooperation and Development (OECD), only a year before the crisis hit. As Asian markets suffered, South Korea’s credit rating plummeted along with the value of its domestic currency. The consequence of this was a doubling in the value of South Korea’s outstanding foreign debt, denominated in foreign currency, as a proportion of gross domestic product (GDP). Insolvent, and facing and economic collapse, South Korea turned to the International Monetary Fund (IMF) for help.

The IMF provided billions of dollars of funds to bail out the most seriously affected countries and to help stabilise currency values. In return for this assistance, the IMF imposed structural adjustment programs (SAPs) in the region. The SAPs forced austerity, as government spending was reduced and widespread reforms aimed at opening up banking and financial services were imposed. It is worth noting that these reforms are the opposite of those now being enacted and considered as a response to the current credit crunch by developed countries. After achieving the status of successful high-income economy, with a stable democracy, the South Korean government was faced with implementing policy decided in Washington.

The actions of the IMF during the Asian financial crisis are often seen as the high point of the neo-liberal Washington Consensus. Yet, in a practical sense, the crisis also marks the endpoint of that consensus, too. In the West, we refer to the widespread default on foreign debt and the subsequent economic consequences as the ‘Asian financial crisis’. The other term to describe these events, more common in Asia, is the ‘IMF crisis’. The impotence of national governments in the face of debt defaults sent a clear message to Asian governments: if South Korea, a democratic, free-market economy and a member of the OECD, could be treated in such a manner by the IMF, what then for China?

China was largely unaffected by the financial crisis at the time. But had China required similar aid from the IMF, it may not have been forthcoming. The reserves that the IMF can command are woefully inadequate to bail out an economy the size of China. Today, China’s economy is almost four times as large as it was in 1997. More than this, China’s communist leadership clearly has more to fear than democratic South Korea from interference in its domestic affairs from the IMF.

The shift to savings

The immediate response to the crisis was a dramatic fall in investment rates throughout the region as capital was returned to the developed world. Deficits on these countries’ current accounts – the balance of payments going in and out – quickly turned to surplus. But despite the threat of economic collapse, the dynamic growth of Asia soon resumed. Investment rates began to increase to former levels, and have recently surpassed pre-crisis rates.

The difference this time was that these soaring investment rates were financed by domestic savings rather than foreign loans. Investment rates in developing Asia are double those seen in developed economies, and yet these same economies are also exporting capital to the developed world. The relationship of debtor and creditor switched as a result of the crisis; Asia became a net exporter of capital to the developed world. The destination of much of this excess capital was America, and to a lesser extent the United Kingdom. As current account surpluses rose in Asia, current account deficits soared in America and the UK.

See graphs comparing international levels of investment and current account balances

The experience of the 1997/98 Asian financial crisis resulted in developing nations pursuing policies to build up foreign-exchange reserves as a safeguard against future crises. But the build-up of foreign-exchange reserves also reflects the success of economic growth within developing nations. Now, many countries are coming up against the logistical limits to already-high rates of investment. China is reinvesting over 40 per cent of the wealth it creates. In the process, millions of people are being brought into the labour market each year. But in order to build new factories, cities, roads and airports, China needs to produce or to import increasing amounts of raw material and fuel, and requires a constantly increasing supply of skilled and educated workers. It takes a long time to train skilled workers and develop infrastructure, so adding more and more money can’t always produce results. In the meantime, China is lending the funds it cannot immediately use to the West.

The role of sovereign-wealth funds

Exporting capital has long been a policy pursued by resource-rich economies, like the major oil producers, through the use of sovereign-wealth funds. These funds convert one asset into another; for example, turning oil into financial assets like bonds and shares. Oil is extracted from the ground, sold to the rest of the world, and, in exchange, oil-exporting countries effectively receive IOUs.

Norway, a country with a per-capita income far higher than the United States, has perhaps the most transparent sovereign-wealth fund. In order to avoid seeing the value of oil revenues destroyed through inflation as massive foreign revenues chase limited domestic goods, Norway places much of its oil revenues in sovereign-wealth funds. The sovereign-wealth fund then invests this capital abroad, effectively lending oil revenues to the same countries that have bought its oil. What has changed over recent years is that countries that receive revenues from manufacturing and services, rather than simply extracting natural resources, have amassed significant foreign-exchange reserves, too.

China has been lending America the funds with which America has been buying China’s exports. Another significant aspect of this development is the form in which foreign assets are held by developing economies such as China. Instead of taking the form of risky and illiquid foreign direct investment, building factories and setting up businesses abroad, the majority of foreign-exchange reserves are held in safe liquid investments. China has not built factories in America, but has purchased US treasury bonds. This means that the effect of China’s capital export to the United States is not to increase directly America’s productive capacity, but to increase America’s supply of credit (although the borrowed money can be used by Americans to build factories and machines, as well as cars and houses). China, along with many other economies, has opted for assets that can be turned into cash at a moment’s notice – assets that provide low returns.

Thus, the origin of the cheap credit that has led to the credit crunch can be understood not simply as the result of poor monetary policy, a lack of regulation and reckless bankers, but as a consequence of changes in the nature of global production. This analysis leads to further questions about how the current crisis may be resolved.

Are global imbalances unwinding?

The prospect of a lasting recession in the United States and the United Kingdom may have the effect of unwinding the imbalance between production and consumption. As imports and consumption fall, current account deficits should also fall. This is nothing to celebrate. Readjusting production and consumption by reducing consumption in the developed world, with the knock-on effect of reducing exports (and production) from the developing world, is a recipe for pain all round.

A further change that has taken place over the past year is the fall in the value of the US dollar and the British pound. This has the affect of making imports more expensive for America and the UK and the goods they export are cheaper for foreign buyers. In the context of a credit crunch, the impact this change may have on stimulating domestic production may be limited, especially for America. The American slowdown has been cushioned over the past year as exports have risen due to a fall in the value of the dollar. However, this cushioning affect appears to have now come to an end. As the crisis has worsened over recent weeks, the dollar has actually strengthened. The more uncertain the outlook becomes for the global economy, the safer the America dollar appears to investors.

Can China bail out America?

Perhaps more significant in understanding the impact the credit crunch may have on realigning global imbalances is the affect of the proposed bailout packages upon the stock of debt within America and the United Kingdom.

As capital has been transferred from Asia to America and a financial bubble has been created in the housing sector, China has ultimately received IOUs from American homeowners. A practical example of this can be seen in looking at the accounts of the mortgage institutions Fannie Mae and Freddie Mac. China has invested $340billion dollars in the loans issued by these two institutions. The ultimate debtor for these loans is the American homeowner. With the nationalisation of Fannie and Freddie, the US government is now acting as guarantor for China’s money. As governments around the world recapitalise failing banks through government investments, the IOUs that have ultimately been extended to the private sector through the intermediation of Wall Street and the City are being moved onto government balance sheets.

The United States government can bail out US banks, but by definition, it cannot bail out America, merely change where the debt ultimately rests. The same is also true of investments from sovereign-wealth funds or from transfers from foreign countries’ foreign-exchange reserves. For China to recapitalise US banks, it must first sell US treasury bonds. Replacing a treasury bond IOU with a share certificate IOU would do nothing to solve the underlying problem.

Conclusion

Recapitalising banks through government debt and the actions of central banks to ensure an adequate supply of liquidity in the money markets are both important measures that may help to avoid a severe and lasting depression. Technical fixes they may be, but they are no less important because of this. We should still be aware, however, that there is a serious problem with the manner in which the global economy operates. The global economy has failed to capitalise on the product of an extraordinary period of sustained growth. We have been brought to our knees by the wealth we have created over recent years. The world is not short of capital to invest or places that need capital investment. The fact that rapid growth in Asia and the world economy more widely has generated a financial bubble rather than led to a further expansion of wealth is a problem that needs addressing. The credit crunch has shown that what we lack is a way of rationally utilising the wealth we create for our own benefit.

Stuart Simpson is the convenor of the Institute of Ideas’ Emerging Economies Forum.