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One conventional view of global imbalances begins by noting that over the last two decades, China and other rapidly-growing economies in Asia undertook development and exchange rate policies that encouraged exports and raised domestic savings. The integration of those economies into the world’s trade and financial systems brought about, in mirror image, high trade deficits and steep borrowing in richer, developed economies like the US.
This account deduces that high savings out East caused borrowing and current account deficits elsewhere — capital flowed uphill from the poorer countries to richer ones — because world interest rates were low and falling throughout the 1990s and early 2000s. The world confronted a Global Savings Glut driven by Asian Thrift. Outside of Asia, current account deficits and high borrowing were simply passively responding to market signals.
The low world interest rates did more than induce high borrowing in the US. They sparked a race for yield, where financial market participants were compelled to search ever more creatively for higher returns, overlooking how greater returns obtain only with greater risk. The financial sector ballooned as banks lent to yet other banks, dealing in progressively exotic financial instruments. Unnoticed, this massive build-up replicated many times over the risk of the original outlays.
In 2007, these multi-varied chains unwound off the US subprime mortgage crisis, resulting in a 180º turnaround in the blind faith which previously was the norm in financial transactions. Before, financial instruments that were only dimly understood were nonetheless transacted in billion-dollar volumes. Now, parties face each other with a general lack of trust. Normal lines of business — almost surely, the majority of them worthwhile — cannot raise funds, so goods and services are simply not being produced and traded.
What’s wrong with this picture?
There are many things instinctively attractive, and likely even right, with that global picture I just drew.
The US began from trade balance in 1990 and then over the next couple of decades, saw its current account explode into progressively larger deficit. By 2006, the US economy was consuming US$900 billion more than it was producing. That trade deficit, 7% of US GDP, was alone as large as the total output of goods and services produced by the billion-people economy of India. Despite this massive US borrowing on international capital markets, world interest rates and inflation rates were low and falling. But some of the reasoning in the story does not hold up to scrutiny.
For one thing, why did financial markets, faced with low returns, turn creative in exactly the way that they did. Sure, easy credit facilitates greater borrowing. But in the history of the world, most borrowers, when faced with high or low interest rates, somehow find a way to behave responsibly and not over-extend their financial dealings.
Why then the “race for yield”? This part of the story is important and is something we are only beginning to understand. But just as important is the Asian Thrift side in explaining the global economic crisis.
Asian Thrift
When you plot US bilateral trade accounts against China, the timeline mimics the US trade deficit overall. Doesn’t this mean China’s economic policies drove global imbalance?
When you graph US bilateral trade accounts against the EU, the timeline there too mimics the US trade deficit overall. Indeed, when you plot US bilateral trade accounts against the oil-exporting countries, again, that timeline mimics the US trade deficit overall. When you add together EU and oil-exporter trade surpluses against the US, the result is a bilateral trade surplus series that matches almost exactly China’s bilateral trade surplus against the US.
It turns out that, as a fraction of its overall trade deficit, the US trade deficit against China has been pretty much constant the last 20 years, as have been the ratios for the US trade deficit against the EU and against the oil exporters respectively.
The fact is, for the last two decades, the US has been massively over-consuming not in any special way relative to China or East Asia. Instead, the US has been doing this against most of the world.
If the cause of global imbalance is Asian Thrift or under-priced Chinese renminbi, then there must also have been EU Thrift and Oil-Exporter Thrift, and under-priced European currency and under-priced oil. Perhaps so. But a more parsimonious explanation is that US profligacy drove the entire constellation of global imbalances: running large trade deficits became the US’ comparative advantage.
Global policies
Under the view that surplus savings drove global imbalances, the policy recommendation on many people’s agenda is to get the surplus countries to boost domestic demand. If global imbalances were due to some surplus country — say, China — manipulating its currency or otherwise under-pricing its exports, then reasserting the correct prices there would again restore trade balance. In each case, the move would further allow the current deficit countries to grow from the increased international demand without worsening their trade deficit position. Global balance would begin to be restored.
If, however, the root cause of global imbalances was the profligate habits of the current deficit countries, something more nuanced is required. What that alternative policy recommendation is should also reflect some perhaps lesser-known facts about the current global distribution of economic activity.
World GDP now runs about US$50 trillion a year. The US, on the one hand, and the UK and the Euro region on the other, each accounts for about one-quarter of the world economy.
In counterpoint, however, consider the following.
The last two times the US economy went into recession was 1991 and 2001. In the first of those, US output actually fell, the same way it will do this year. But in 1991, China contributed to world economic growth three times at market exchange rates what the decline in US GDP turned out to be — East and Southeast Asia contributed nearly 20 times. In 2001, China contributed to world economic growth nearly one and a half times the US’ contribution, again at market exchange rates — East and Southeast Asia, nearly double.
Over the recent US recessions, East and Southeast Asia have more than respectably held up their end of world economic growth.
Of course, as is true every other time as well, this time the recession is different. Emerging economies now face sharply declining export demand, falling commodity prices, and rapidly shrinking FDI. In the category of bad news, Taiwan’s exports in January 2009 are 40% lower than a year ago. In South Korea, the decline in industrial output over the past year is the steepest on record. Russia’s industrial output fell 20% in January from the previous month. Japan’s industrial production fell by 21% in the three months to November 2008, and its GDP fell last quarter by the steepest rate of decline since 1974.
Even China’s exports fell 13% in 4Q2008. But actually this means they are only 3% lower at the end of 2008 than a year before, hardly a catastrophic collapse. Even without a global economic and financial crisis, China’s economy was already having a rough 2008, with paralysing ice storms in February last year, the massive Sichuan earthquake in May, and then the tight grip of the Beijing Olympics in August.
On a more positive note, the Shanghai stock market has continued to rise since China’s RMB4 trillion fiscal stimulus announcement last November — it was up 13% by mid-February this year from the start of the Chinese New Year. Total bank loans in China rose 19% at the end of 2008 from the 12 months before, and continued their climb in January. New cellphone subscriptions in India reach a record of 11 million in January 2009, as rural customers — who don’t typically own land or hold extensive financial portfolios, and so are unaffected by plunging stock markets and real estate prices — continue to see the benefits from digital mobile telecommunications. Malaysia’s financial system has only 0.3% of its banking capital exposed to the US subprime mortgage market, and profits remain high.
Sure, export demand is down everywhere but, with some notable exceptions, many of Asia’s financial structures are now relatively stripped of short-term foreign-currency denominated commercial bank loans.
To be sure, there has never been any question that some export demand decline in the circle of economies surrounding China would be in the works, given the sharp reduction in US and EU demand. Globalisation pretty much forbids decoupling.
However, globalisation lives quite happily with clustering. So, three things useful to know about Japan, still the world’s second largest economy: First, as a fraction of Japan’s total trade that it undertakes with China, has more than tripled in the last 15 years; second, Japan’s trade with the US reached a peak of 35% in the mid-1980s, and since then the ratio has fallen to 15%; and third, Japan’s trade with China exceeded that with the US for the first time ever in 2006 and continues to expand.
And, finally, three similar things to remember about South Korea, Asia’s largest economy after Japan and China: First, as a fraction of Korea’s total trade that Korea undertakes with China, has quadrupled in the last 15 years; second, Korea’s trade with the US topped out at over a third in the mid-1980s, and since then it has fallen to only 10%; and third, Korea’s trade with China exceeded that with the US by 2004, even earlier than did Japan’s, and continues to grow too.
Policy prescription
What does this leave on policy prescription? Three emerge.
First, much of the world’s banking and financial systems need to be rebooted. Financial intermediation needs to resume. But just as in rebooting a modern computer system, the virus — toxic debt in this case — needs to be isolated and excised, or otherwise the system will simply be reinfected when it does come up again. A “bad bank” that concentrates all toxic assets, leaving the rest of the financial system clean for normal operations, seems to me a good idea. Similarly, a “new bank” that begins uninfected, starting with a clean slate, can achieve the same purpose.
Second, rebalance the global economy by all means, but with an eye to fostering aggregate supply as much as aggregate demand. The current paradox of policy is that while it was the massive amount of over-extended debt that unwound sharply to generate the fear, uncertainty and doubt currently incapacitating credit channels, many policy proposals are asking for even more debt to finance demand stimulus. Give the surplus countries their own lead. If surplus countries are being urged to no longer save, who will now buy US Treasury bills?
Third, if excess savings in one part of the world are a problem for the global economy, recognise that they are a nation’s savings, not an individual’s. Chinese consumers have savings rates not dramatically different from consumers elsewhere (everywhere, of course, except for the US). Instead, it is the corporate sector and the government together that provide the bulk of high savings in China. If a nation saves more because it confronts high national risk and insecurity, the situation is not helped by stoking yet greater fear from external protectionist and alarmist rhetoric.
Danny Quah is professor of economics and Head of Department at the London School of Economics
This article appeared in The Edge Malaysia, Issue 747, March 23-29, 2009.
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