Green shoots: grounds for cautious pessimism

I am not going to use this opportunity to deepen the gloom by exploring at length the possible consequences of a worldwide pandemic of a virulent form of swine flu.  Just a few depressing words will have to suffice.  From an economic perspective, a flu pandemic amounts to at least a temporary reduction in the effective supply of labour.  If flu-related mortality is high, there will be a permanent reduction in labour supply.  The dependency ratio rises (temporarily or permanently, depending on whether mortality increases).  Trade and travel are interrupted.  A flu pandemic therefore represents an adverse supply shock.  Notional consumption demand need not decline materially, but effective consumption demand may well be depressed if many would-be shoppers cannot reach the sellers of goods and services or arrange for delivery.  Investment is bound to suffer.

A flu pandemic therefore also represents an adverse shock to aggregate demand.  It is bad news on both the demand and supply side.  It will however, impact favourably on global warming.  Now you know.  In what follows I will analyse global economic prospects on the assumption that there will not be a global swine flu pandemic.

The real economy downturn in the US is about 1½ years old; the UK recession has been with us for at least three quarters; the rest of Europe, Japan and most emerging markets and developing countries have juvenile recessions, barely a couple of quarters old.

As regards the overdeveloped world, or at least the North Atlantic part of it, the odds are that this contraction of real economic activity will be deeper and last longer than other post-war recessions. The reason is that other post-war recessions were either the results of central banks murdering a boom that threatened price stability or of an exogenous oil price increase (Opec I and II).  Following both types of downturns, the financial system (markets, banks and other systemically important institutions) were, on balance, in good shape (cyclically adjusted!).  Banks suffered as a result of the decline in demand for external financing by households and non-financial enterprises caused by the recession, and from the increase in arrears, defaults and other delinquencies that come with an economy-wide slowdown.  But the capacity of the system for providing intermediation services and external financing for households and non-financial enterprises was typically in reasonable shape.

Not so today.  The crossborder North-Atlantic financial system had collapsed before the downturn in the real economy got going in earnest.  Indeed, the financial collapse was the primary cause of the recession in the USA, the UK, Iceland and most of the rest of Western Europe.  We know from the studies of Reinhart and Rogoff and of Laeven and Valencia that real economy contractions that follow a financial crisis tend to be both longer and deeper than those that don’t.  Specifically, following deep financial crises, the unemployment rate rises an average of 7 percentage points over the down phase of cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, and the duration of the GDP downturn averages around 2 years.[1]

US real GDP growth was -0.2 percent in 2007, Q4 (on the previous quarter), but became positive again the next two quarters (0.9 percent growth in 2008Q1 and 2.8 percent in 2008 Q2).  Since then, growth has been negative, with  -0.5 percent in 2008Q3 and -6.3% in 2008Q4.  The Reinhart-Rogoff downturns are measured from previous peak GDP, which was 2008Q2.  If the US conforms to the average of the post-World War II serious financial crisis countries studied by Reinhart and Rogoff, negative GDP growth would persist until 2010Q2.  Growth after that would be slow and hesitant.  The 2008Q2 level of GDP would be regained at the earliest around the middle of 2012.  Unemployment would still be far above the 2008Q2 level at that time.

There is little reason to assume the US will do better than the average achieved post-world war II.  Its room for discretionary fiscal stimuli has been more than exhausted.  Almost two years have been wasted since the beginning of the financial crisis as regards getting past toxic assets off the balance sheets of the banks.  The US regulators and Treasury have put the interests of the unsecured creditors of the banking system ahead of those of current and future tax payers and beneficiaries of public spending.  Worse than that, by failing to come up with the required amount of up-front fiscal resources to clean the balance sheets of the zombie banks, recapitalise the banks and, where necessary, guarantee new lending and borrowing, the US authorities have relegated most of the banking system to a state of limbo in which far too little new lending to the real economy is undertaken.  The sloth-like speed of the stress tests and the six months grace period granted banks deemed short of capital to come up with new capital on their own, contribute further to my sense that the authorities in the US are doing everything they can to make sure that the US gets as close as possible to emulating Japan’s lost decade.

Bank profitability

What limited bank lending takes place is often at high interest rates, and is funded at government-subsidised rates (about $340bn worth of borrowing by banks has so far been guaranteed by the state).  These tax-payer-engineered high spreads on limited new lending, plus the welcome transfusion of taxpayers’ money through AIG paying off its counterparties at 100 cents on the dollar gave a useful boost to many banks’ Q1 profits.  Add to that the under-provisioning by many banks for new loan losses, plus the new latitude granted by the FASB to banks wishing to window-dress the depressed mark-to-market value of some of their securities, plus the wonderful accounting convention that permits banks to count as revenue reductions in the market value of their traded debt caused by a loss of market confidence in their creditworthiness, and the banking profitability green shoot is visibly wilting on the vine.

Disguising the new damage done to the banks’ loan book by the contraction of the real economy will become harder as time passes.  By the end of the year, I expect that the combination of the stress tests and the reluctant revelation of new bad loans may bring us to the point that even the authorities can no longer shrink from restructuring the insolvent components of the banking system by forcing the unsecured creditors to swap their debt and other claims for equity.  Only then can the banking system as a whole begin to function normally again – one hopes under very different rules of the regulatory game.

The inventory cycle

The inventory cycle is short and sharp.  Statistically, inventory accumulation and decumulation often account for more than 100 percent of the business cycle.  This is unlikely to be the case in the current cycle.  Final demand (private consumption, private fixed investment, exports and government spending on goods and services) is contributing to the downturn and will have to turn around to achieve a sustained recovery.

With financial intermediation in tatters, external finance for would-be financial deficit units, households or firms, will be hard to find and expensive.  Most households have suffered massive losses of financial wealth and will want to restore their financial health by saving more.  Other final demand components are also unlikely to become buoyant in a sustained manner anytime soon.  Private fixed investment is likely to be week for the next couple of years because of prevailing excess capacity and limited availability and high cost of external funds.  US export growth inn unlikely to be a major source of demand.

Government spending will grow quite rapidly, but the dire fiscal condition of the Federal government effectively precludes further discretionary expansionary fiscal measures.  Federal government deficits significantly larger than those envisaged here would unnerve the financial markets and trigger a buyers’ strike in the US Treasury debt markets, either because of a fear of default (quite unlikely) or because of a fear of large-scale irreversible future monetisation and inflation (quite likely).  I know it’s not priced in the long-term US government bond yields yet, but this would not be the first time financial markets have been wildly irrational in recent years – so just you wait.

Asset price stabilisation

House prices continue to fall.  While house price changes don’t have an aggregate wealth effect, they do affect the capacity of households to borrow, because property, unlike human capital, makes rather good collateral.  Until house prices stabilise, it is hard to see consumption reviving.  Even with the recent (in my view premature) recovery in the US equity markets, stock market wealth in the US has come down spectacularly from its previous peak, and is now, in real terms, at about its 1996/1997 level.  Talk of a lost decade…

Europe

In Europe, the UK is in many ways the US with a half-year lag.  The size of its banking sector relative to the economy and to the fiscal capacity of the government and the absence of global reserve currency status for sterling makes the UK more vulnerable than the US to a triple crisis – banking, exchange rate and sovereign debt.  The ability of the UK authorities to raise future taxes or slash public spending is, however, likely to be greater than that of the US, whose political system is polarised to the point of paralysis.  The US, like the UK, is therefore at risk of a ‘sudden stop’ (an unwillingness of anyone to fund the sovereign and an unwillingness of the rest of the world to fund either the private or public sectors of the US), as long as US political infantilism, especially in the US Congress, guarantees a veto for any sensible (or even just arithmetically feasible) proposal for solving the scary fiscal unsustainability problem of the US.

The rest of Western Europe is dead in the water.  The ECB is paralysed, partly by fear of the zero lower bound on interest rates among some of its Governing Council, partly because of the absence of a ‘fiscal Europe’, capable of recapitalising the ECB/Eurosystem should it suffer a serious capital loss as a result of private sector credit exposure incurred as a result of its monetary, liquidity enhancing and credit enhancing operations.  Countries that have fiscal credibility and could do more as regards Keynesian fiscal stimuli, like Germany and France, refuse to do so.  The recession in Western Europe started about a year after that in the US.  It will last at least as much longer.  The banking system of Western Europe (ex-UK) has been even more reluctant than that of the US and the UK in owning up to the disastrous state of its balance sheet.  At least €500bn additional capital will be required to keep the continental West-European banking system on its feet.  More will be required if it is to actually start lending in earnest again.

Japan

I don’t understand the Japanese economy.  Never have.  Probably never will.  Will they be a locomotive for the rest of the world?  Everything’s possible but not everything’s likely.

Japan’s public debt to GDP ratio is 180% of GDP and rising.  Yet even long-term rates on nominal public debt remain very low.  The main reason is, I believe, that while the Japanese state runs a massive financial deficit, the Japanese private sector runs an even more massive financial surplus.  The consolidated financial position of the country has been one of persistent current account surpluses.  Private financial wealth is huge and the net international investment position of the country is a large positive number.  (Italy has a milder version of the same configuration of private and public saving and borrowing propensities).

So if the markets believe that the Japanese political system is and will be capable of achieving, sooner or later, the large resource transfer from the private sector to the public sector that is required to make the public finances sustainable, the overall financial position (flows and stocks) of the country is what matters.  And these consolidated national flows and stocks still look pretty good.  This in contrast to the US and the UK, where looming fiscal deficits combine with low private saving propensities to create enduring doubt about fiscal sustainability.  As regards Italy, I am less than fully confident that the Italian tax payer/beneficiary of public spending will do as (s)he is told by the nation’s fiscal authorities, now or in the future.

Emerging markets

The prospects of the emerging markets depend, first, on their dependence on external demand, second, on their dependence on external finance and, third, on the scope for expansionary domestic demand management and the ability of the authorities to use it intelligently and flexibly.

No emerging markets suffered the destruction of their banking systems prior to going into recession.  Their contractions are the result of the external transmission of the north-Atlantic financial crisis and contraction, through trade linkages, through deteriorating terms of trade (especially for commodity producers), through falling remittances, through the financial markets and through the parent banks of foreign-owned local subsidiaries and branches restricting the availability of re-financing and new funding to their local subsidiaries and branches.

The emerging markets that are best poised to enjoy a speedy recovery (following a V-shaped recession) are those that do not depend excessively on external finance and on external demand.

China certainly fits the bill as regards lack of dependence on external finance.  Like many other emerging markets that suffered through the Asian and Russian crises of 1997-1998 or observed it closely, China self-insured against an interruption of external financing flows by building up massive liquid foreign exchange reserves.  Chinese reserves today even exceed those of Japan.  India, Brazil, Korea, Malaysia, Singapore and Taiwan also built up large foreign exchange reserves.

China does not fit the bill, however, as a candidate for a sustained early recovery because of its external trade dependency.  Growth in demand for its exports will not revive anytime soon.  The country is not large enough to pull itself up by its own boot straps, unless it achieves a radical restructuring of its production and a shift in the composition of final demand away from exports and towards domestic final demand.

China recognises this and has thrown the kitchen sink at the problem.  Although it is hard to understand the exact size of the fiscal stimulus it has provided, there is no doubt that this stimulus was large.  Interest rates have been cut.  Credit growth, including bank lending to state enterprises and to construction has exploded.  The problem with this approach is that the composition of the demand stimulus and production boost is completely wrong.  The government has simply done more of whatever it was doing in the past: increased investment in the production of exportable goods and heavy industry (metals and chemicals), increased production of semi-finished manufactured goods and increased investment in infrastructure.  The inevitable result of this investment boom will be increased excess capacity in exportables and unprecedented environmental destruction.

China is missing a huge opportunity.  Its short-run imperative (boost demand through a fiscal stimulus) coincide with its long-run imperative (reduce the national saving rate and the external current account surplus).  This stands in sharp contrast to the US and the UK, where the short-run imperative (boost demand through a fiscal stimulus) conflicts 180 degrees with its long-run imperative (save more and reduce the external current account deficit).  China saves too much in the household sector, the corporate sector (especially the state enterprises) and the public sector.  It badly needs an unfunded pay-as-you go social security retirement scheme to boost consumption by the old.  China’s fiscal position is such that the country could introduce the benefit (pension) part of the social security scheme for a number of years without having the social security tax in place!

China’s rapidly greying population and the one-child policy mean that, without a credible, universal, publicly funded social security retirement scheme, it is individually rational to save like crazy, because neither the state nor your children will be able to look after you in old age.

Another way to boost public consumption (and reduce household saving), is to guarantee decent quality medical care for all regardless of ability to pay.  Saving to pay for private tuition for one’s (only) child is another important driver of private saving in China.  Providing better quality public education could free private resources for consumption.

But a boost to consumption demand (private and public) of this nature requires a matching change in the structure of production towards consumer goods and services and away from heavy industry.  China hasn’t even begun to address this shift of demand towards non-traded goods and imports and of production towards consumer goods and services.  Even if its ultra-old-school demand stimulus does not get killed (yet) by environmental constraints (clean fresh water, clean air, clean soil etc.), it will certainly be killed by mismatch constraints as the country adds massively to its capacity to supply goods nobody wants.

The green shoots we may be seeing in China will therefore not endure unless the country manages, very rapidly, a radical change in the composition of its production and consumption.  That is possible, but not likely.

A country like India – much less dependent than China on external demand but rather more dependent on external finance – could also recover rather soon, and in a more sustainable way, especially if it finds a way to further stimulate domestic saving.  But its weight in the world economy is slight – not enough to be a locomotive, not even the little engine that could.

Other emerging markets, like Brazil, have been hit hard by the global downturn and by the freezing up of key financial markets despite being net foreign creditors and running external surpluses prior to the crisis.  Brazilian corporates were heavily exposed to the international financial markets, often at short maturities.  While the central bank, thanks to its large foreign exchange reserves, was capable of preventing large-scale defaults, the financial squeeze on Brazil’s corporations, plus the terms of trade shock and the decline in export demand has caused the country’s industrial production to fall off a cliff.  One would expect it to be able to recover sooner than the US or Western Europe, if it can direct demand towards domestic sources.

Eastern Europe (including the CIS) is the most dramatic victim of the made-in-Wall-Street/City-of-London/Zurich crisis.  Virtually all countries in the region were heavily dependent on external financing and on foreign trade.  Some, especially in the CIS, are major commodity exporters.  Western banks are often the parent banks of the local branches and subsidiaries.  As the barbarians threatened Rome, headquarters withdrew the Legions from the provinces.  Parent banks are ruthlessly cutting the access to funds of their subsidiaries and branches in CEE.  No help will come anytime soon, with the members of the old EU barely capable of keeping their own trousers up.

Conclusion

The only reasonably convincing evidence of ‘green shoots’ comes from China.  That, however, is unlikely to be sustainable, as it is very much the result of a ‘same-as-it-ever-was’ package of fiscal, monetary and credit policy measures by the Chinese authorities.  The export- and heavy-industry led expansion they have successfully engineered is the way of the past.  It will go nowhere, unless China transforms the composition of both production and demand in the directions that are unavoidable (and also desirable) for a country at its level of economic development.  Apart from China, the only green shoots I have seen were in the salad bar of the hotel I am staying at.


  • Laeven, Luc and Fabian Valencia (2008), “Systemic Banking Crises: A New Database”, IMF Working Paper WP/08/224, November.
  • Reinhart, Carmen M. And Kenneth S. Rogoff (2008a), “Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison”, February .
  • Reinhart, Carmen M. And Kenneth S. Rogoff (2008)b, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”, April.
  • Reinhart, Carmen M. And Kenneth S. Rogoff (2008c), “The Forgotten History of Domestic Debt”, April.
  • Reinhart, Carmen M. And Kenneth S. Rogoff (2008d), “The Aftermath of Financial Crises”, December.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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