Nikkei Veritas – Market Eye column, 27th July 2011
There has been a profound change in the world economy. From 1950 to around 1985, the developed and emerging worlds grew at a similar pace; since then the less developed countries have been catching up. Unless some very bad mistakes are made in economic management these trends should be maintained. While living standards should continue to improve worldwide, those of poorer countries should be rising much faster and the gap between rich and poor will be closing and the world as a whole will be growing faster than before. This is a most desirable development to be rightly welcomed by all people of good will.
As living standards rise in developed economies, the increased demand is mainly for services but, in the case of emerging economies, goods and raw materials are much more important. In general, goods and raw materials require more capital to produce than most services. A world which is growing faster than before and where the growth is concentrated in poorer countries is likely to be a world where the proportion of GDP which is saved and invested needs to rise.
This is very fortunate. Major economies, including Japan, the UK and US, have massive budget deficits which they must bring down. This process will automatically cause an equal rise in their national savings, unless it is thwarted by recession. But it is most unlikely that these countries can sensibly increase their domestic investment. If we are to avoid another recession, much of the additional savings that are generated in developed economies as they cut back on their government deficits will need to flow abroad to finance investment in the rest of the world.
The needs of the developing world for more investment fit perfectly with the needs of the developed part to increase their savings. If this is allowed to happen, the outlook for the economy is excellent. Unfortunately there are lots of reasons for fearing that changing from the world in which we find ourselves today to one where savings flow from the developed to the emerging world is going to be bumpy rather than smooth.
Economies have to adjust all the time, as they change. The process is seldom completely smooth. Mild booms and recessions are part of the usual adjustment process. But it is vital that we avoid another sharp recession like the one from which we are just emerging. This is not only because the last one was so painful, but also because we cannot repeat the massive doses of fiscal and monetary policy which were used to assuage that pain. Budget deficits cannot again be increased or interest rates reduced sharply.
To avoid a sharp recession the adjustments that we need must work steadily rather than sharply. Government deficits need to come down and international capital flows improve, but in both cases they need to do so steadily rather than dramatically and we need to avoid sudden shocks from other sources.
Sudden shocks cannot be forecast – as they would not be shocks if they could. But we can assess and try to reduce the risks of some shocks. Unfortunately those in charge of the world economy show little understanding of some key risks and are therefore failing to reduce them. The most obvious risks of short-term shocks in the world at the moment are the US fiscal deficit, the sovereign debt crisis in the Eurozone and the fragility of the world financial system to the combination of high debts and high asset prices. I am optimistic that none of these issues will give rise to shocks over the next year or so, but it is difficult not to be pessimistic looking further ahead.
The US Congress needs to agree by August 2nd that the national debt can rise above its current limit of $14.6 trillion. If it doesn’t, there will be a crisis of some sort, though how serious it will be is widely disputed. There are, it seems, ways in which the problem can be circumvented in the short-term. But the longer term problem is more serious. Serious steps to cut back the US deficit, which is running at over 10% of GDP, are both essential and inherently unpopular. The first year of a new government is the most likely time to bring in unpopular measures as it gives voters more time to forget. There is therefore likely to be considerable disappointment in the US bond market if such steps are not agreed in 2013, after the next election.
But it is not only essential to avoid an extreme shock to the bond market, it is also necessary to avoid one to the equity market. Insufficient reduction in the deficit risks the former and an adequate one the latter, because of the negative effect on corporate cash flow. We must hope that it is possible to strike the right balance and avoid a shock of one sort or the other to financial markets. Unfortunately we must not only hope that this is possible in theory, but we must also hope that it can be achieved in practice through the political processes of the US.