GLOBAL 4 AUGUST 2011

A persistent theme of recent and

current events in the global economy
and here at home in Zimbabwe too
is the idea of the New Normal.
This is the belief that the global and
local economies have undergone,
and continue to undergo, radical
change which means that the past is a
poor guide to the future.
 Japan is a good place to start.
Remember it was one of the star
performers in the global economy
from 1960 to 1989.
Until the early 1990s it was
fashionable to see Japan as the
economy that would overtake the US
and whose business model was far
more efficient than those of the West.
 In the 1960s Japan grew 10%
annually, slowing to 5% in the
1970s and 4% in the 1980s.
But today all that is a distant
memory.
Japan is in serious trouble. Why?
 Over the last ten years, the level of
debt-to-GDP has risen from 99% to
over 170%.
This was because the government
ran massive deficits to reverse the
Lost Decade of the 1990s, following
the crash of their real estate and
stock markets, starting in 1989.
 Japan invested massively in
infrastructure, building bridges and
roads to nowhere.
All sorts of spending programmes
were launched and
the Central Bank went in for
quantitative easing printing money.
 Does any of that sound familiar?
It did not work and 20 years later
Real Estate prices are down 50%
to 80% depending on location,
while the share market is 75%
lower than it was in 1989!
 Because pension funds and
personal savings were as high as
16% of GDP the govt used to be
able to borrow at very low interest
rates 1% to 1.5%
Demographics are changing that
situation
 The New Normal situation is that
Japan now has 1.2 non-productive
persons (under the age of 15 or over
the age of 64) for every working age
person.
By 2020 the ratio will be two-to-one
and by 2050, six-to-one!
 As populations age, so savings
rates fall because the elderly have
to live off their savings.
The Japanese savings rate has
collapsed from 18% of GDP in 1990
to less than 2% in 2008.
 Even though interest rates are still
very low because the govt has
borrowed so much, servicing the
national debt will absorb 18% of the
Japanese budget.
Govt debt is growing by 7-8% a year
while interest rates cannot go lower.
 Savings are falling rapidly and will
not be able to cover the need for new
debt issuance.
Within a few years, because of the
aging of the population, savings will
go negative, while social security
payments are rising.
 GDP is shrinking, and export trade is
off about 30-40%, depending on the
industry.
Machine tool exports are down 80%.
There is a rule in economics: "If
something can't continue, then it
won't."
Japan can't continue down this path.
 Japans problem is a microcosm of
that facing the world as a whole.
It is estimated by a US investment
house that globally govt borrowing
in 2009 exceeded $5.3 trillion of
which $2 trillion was by the US.
 That excludes private sector and
household borrowing (for house
mortgages, etc).
That is about 9% of global GDP at
a time when savings rates were
falling in industrialized countries
though they are now rebounding.
 The net effect is that savings will
average around 23% of global GDP,
meaning that govts will take (say) 10%
Leaving a maximum of 13% for the
private sector and households.
The net result is almost certain to be a
sharp fall in investment in the period
2009-2011 which will mean slower
global growth.
 Most analysts think that the US economy
will continue to deleverage over the next
two years
Households, banks and corporates will
seek to rebuild their balance sheets,
which means:
Saving more
Spending less, and
Repaying debt
 Some analysts the stock market
bulls expect higher savings to
translate into more stock market
investment
But most disagree and expect the
higher savings rates to be used to
repay loans and debts
 Economists increasingly believe
that consumption will fall by 7%
from its 72% share of US GDP in
2007 to around 65% over the next
three years.
Moreover, they believe it will
remain at a significantly lower level.
 In 2007, US consumer spending
accounted for more than 18% of Global
GDP (14.8% in 1980 and 16.8% in
1990).
In other words US consumers have
played a key role in fuelling global
economic growth, especially in Asia and
Latin America where a high proportion
of US consumer imports are sourced.
 Indeed over half Asias total exports
end up in the US.
There is an important technical point
here.
For there to be high levels of
discretionary spending by consumers,
per capita incomes need to exceed
$5000 a year as is the case in
Botswana, South Africa, etc.
 In China only about 8% of the
population fit into that category,
meaning that the Chinese consumer
market, although numerically huge,
is largely confined to people
spending on necessities rather than
discretionary items.
 The point is that if more likely when
US consumer spending dips and
remains at lower levels than before,
Chinese exports will be hurt.
Chinese industry will be hit because
so much of its production
overproduction really is for export.
 Thereis another side to this namely
that China buys only 22% of Asian
exports, so that even if China were to
manage to grow very rapidly the
impact on the rest of the Asian region
and even further afield to Africa
would not be that great.
 Bottom line? There is simply not
enough available capital under current
conditions to do it all.
Something has to give. More
household savings? More foreign
investment (flight to safety, as the rest
of the world looks even worse)?
 Reduced corporate borrowing and
thus less GDP growth?
Higher rates to attract more foreign
and US investment?
The combinations are infinite, but
none of them bode well.
 Increased household savings
means less consumer spending. To
attract more foreign investment (in
the amounts that will be needed)
will mean higher rates in 2011 and
beyond.
One trillion dollars is 7% of US
GDP. And the US will be running
trillion-dollar deficits for a very long
time.
 Three conclusions stand out from
this part of the discussion:
1. That China is unlikely to be able
to continue to grow on the basis
of exports, especially exports to
the US and Europe.
2. That China will also not be able
to drive the global economy,
because it will not drive Asian
growth, unless it changes its
growth model.
3. Chinas growth will increasingly
be driven by home consumption,
but, as just pointed out, there is a
problem per capita incomes are
low insofar as discretionary
consumption growth is
concerned.
 Theconclusion is that the US
economy is going to grow more
slowly because firms and
households are saving more,
deleveraging and spending less.
 The US debt-GDP ratio in 2008
was 70%, but within a few years
(say 2012) it could be 110%.
To put this into context, the EU has
a debt ceiling target for members of
the Euro of 60% of GDP.
This would be almost twice that.
Two trajectories that between them
determine the debt-GDP ratio are
critical:
The growth rate of debt, and
The growth rate of GDP
 If the debt ratio continues to rise then
it usually accelerates because of the
rising cost of interest that adds to the
budget deficit and the total debt.
But if the Debt-GDP ratio stagnates, it
tends to be associated with very low
real growth, political paralysis, and a
degree of social disenchantment.
 However, if the ratio falls, it is usually
because of a combination of two
developments:
Higher real growth and
Tough, vigorous fiscal discipline
 The lesson is obvious the US must
keep a tight rein on government
spending and reduce the budget
deficit, while accelerating growth.
 Because of the fall in consumption
spending from 72% to 65% of GDP,
pessimists warn that without a
recovery of household spending to
previous levels, the economy will
suffer for a long time.
That need not necessarily happen
 If investment spending (both in the
corporate sector and in government
infrastructure spending) rises
sufficiently to offset the fall in consumer
spending, then there will not be a
problem.
This is because an invested dollar will
generate more growth than increased
social spending.
 Another worry is the calculation that
credit destruction in the US
economy caused by bank
deleverage and losses is some
$14 trillion.
 But the total amount of new credit
created by the government and
Federal Reserve is only $2 trillion.
This suggests that deflation not
inflation is more likely to be the
problem in future.
 Letme recap on what I have been
arguing so far:
(a) Reflationary policies of the kind
the world is now trying quantitative
easing, propping up banks and auto
manufacturers, cutting interest rates,
lowering taxes and increasing govt
spending, did not work in Japan.
(b) US consumption spending drove
global growth in the 1990s and up
until 2007.
China made the products and the US
bought them, using money invested
in the US economy by oil producers
and China.
 The US consumer has pulled back
and it is not obvious where the
rebound in growth will now come
from once the current policy stimuli
are withdrawn
As they will have to be later this
year
The stimuli are:
Low interest rates
Lower Taxes
Higher govt spending, and
Quantitative easing printing
money
(c) Because China buys relatively
little from the rest of Asia, it is not
obvious that Asia can decouple
from the West.
Again where does the growth come
from?
(d) The US needs to save and invest
more and spend less.
That is likely to happen but will it be
enough?
 The US debt-GDP ratio is going to
rise steeply and to grow faster to
prevent the debt ratio from reaching
Zimbabwe style proportions (190% of
GDP), the US must not only:
Invest more but
Ensure it grows faster.
(e) The US economy has been hit by
the steep deleverage of banks,
which is 7 times the spending
stimulus put in place by the
government.
 As of today (August 2011) there is no
shortage of optimists and analysts
who say that the picture I have been
painting is way too gloomy.
Certainly, the US economy is now
rebounding much more strongly than
seemed possible a Few months ago,
AND
China shows no sign whatsoever of
slowing down.
1. The lack of progress in fiscal consolidation
in major advanced economies
2. The continued weakness of the U.S. real
estate market
3. Rapidly rising commodity prices,
especially of fuel and food,
 4. Overheating and the potential for
boom-bust cycles in emerging markets,
mostly in Asia, and
5. The concern that the Eurozone
sovereign debt crisis will re-ignite in
one of the so-called PIGS Greece,
Ireland, Portugal , or spread to the
fourth Pig (Spain) and worse to an
even bigger economy, Italy.
 In addition to these specific concerns
there is the ongoing worry that while
economies are recovering job growth
is not.
There seems to be a serious
disconnect between output growth
and employment growth.
 Normally the two go together, but in
the New Normal that does not seem
to be the case.
With US govts Federal and State
cutting jobs, the private sector needs
to create 120 000 to 150 000 jobs a
month.
 8.75 million jobs were lost in the US
in 2008-09,
In 2010 private-sector employment
expanded by a little more than 1
million.
Unemployment fell from around 10%
to 9%
 But this fall in the unemployment rate
mainly reflects a decline in the
participation rate.
In the US data, if a person does not
look for a job in the four weeks before
the data are collected, then he/she is
not considered to be unemployed but
to be not participating.
 The number to count is not the
unemployed, but the employed.
In the US the employed peaked at
146 million at the start of 2008 and
then fell to 138 million at the end of
2009 before recovering to 139 million
at present still down 7 million.
 This focus is important because in the
US the central bank has a dual focus
Price stability, and
Foster employment
Most other central banks in industrial
countries have a single focus price
stability through inflation targeting.
 This highlights the Feds dilemma.
The data suggest that inflation is
rising, but the Fed insists that
because there is a large output gap
ie: substantial spare capacity.
Printing money cannot be inflationary.
 Yet the reality is that prices ARE
rising despite the output gap
It is what is known as stagflation.
The two mandates price stability
and fostering employment are
apparently in conflict.
 Recall what was said in BE
There are four dimensions to inflation:
1. Short-term caused by exogenous
effects like devaluation, rising oil prices,
drought or floods etc, And
2. Long term inflation caused by
excessive monetary expansion, usually
driven by large budget deficits.
 3. Cost push which is often outside
the control of the authorities, and
4. Demand pull which they can
influence, though not control, through
higher interest rates, monetary curbs
and tightening fiscal policy.
 Globally there is very little that govts
can do to control food and fuel
inflation.
If they curb demand, that might help
curb fuel consumption, but it6 takes
at least a year for monetary policy to
work.
 The concern is that the current rise in
inflation is not due to what is called
QE2 the second phase of printing
money by the Fed
But over the long haul 2 to 3 years
QE will impact on inflation.
 So in several rich countries there is a
growing call for higher interest rates
and tighter monetary policy
But this is being opposed by those
who say that will stop the recovery in
its tracks and tip the world back into a
double dip recession.
 Meanwhile, some emerging
markets, especially China, are
tightening monetary policy because
they do not have the same output
gap (spare capacity), and
Inflation is approaching 6% in China
.
 The IMFs most recent global economic
update (June 2011) says activity is
slowing down temporarily, and downside
risks have increased.
The global expansion remains unbalanced
as growth in many advanced economies
remains weak, while the mild slowdown in
the second quarter of 2011 is not
reassuring.
 The IMF said that greater-than-
anticipated weakness in the US and
financial volatility caused by the
Eurozone debt crisis posed greater
downside risks.
Simultaneously, signs of overheating
have become increasingly apparent in
many EMs.
 In its assessment the Bank for
International Settlements takes a
different view, warning that the
worlds output gap has disappeared.
By this is meant the gap between
potential and actual production or
capacity utilization.
 When actual production catches up
with capacity, prices start to rise and
inflation accelerates.
The BIS warns that this is what will
happen over the next year and wants
countries to tighten fiscal and
monetary policies to slow demand
expansion.
 Economic growth in the US is the
weakest of any recovery in the past
nine decades.
But the picture is very different for
asset prices.
Commodities, until recently, had
enjoyed their strongest ever
performance in a recovery.
 Until July, the S&P 500 share market
index had enjoyed its fifth strongest
rally in 34 recoveries.
Why have asset prices done so well
when the US economy hasnt?
Part of the story is monetary policy.
 QE2 pumping $600 billion into the
markets by buying Govt bonds
stimulated demand for shares and
bonds, because by keeping interest
rates low the Fed encouraged
investors to buy shares.
 But since QE2 ended in June, three
things have happened:
1. Share prices have tumbled partly
because of debt concerns but also
the slowdown in the economy;
2. The debt deal means govt
spending will be cut thereby reducing
demand.
 3.This has caused analysts to
downgrade their growth forecasts
while unemployment has worsened.
As a result the share price bubble
appears to be deflating, though
markets remain very volatile and it is
impossible to make firm forecasts.
 The recent stalling of the US recovery
raises scary questions.
After a recession, this economy
usually gets people back to work
quickly but not this time.
Optimists say there is no reason to
panic as a number of special factors
account for the midyear slowdown.
 They blame short-term headwinds
for the slowdown:
Bad weather
The phasing out of fiscal and
monetary support
The Japanese earthquake
The Eurozone debt crisis
The surge in oil and food prices
 Whether this optimism that as these
believed-to-be short-run influences
fade, the US and global economies
will recover more strongly remains to
be seen.
It is simply too early to say
 But what is clear is the policy
dilemma the policy divide.
The reflationists Stiglitz,
Blanchflower, Krugman, the UK
Labour party etc warn that the
global economy is heading for a
double-dip recession.
 They want:
More QE
Increased govt spending
No increase in interest rates
Some tax cuts
This they say will revive stalling
economies.
 The austerity group wants:
Firm action to cut govt budget deficits
and cut the debt burden;
This meant spending cuts and higher
taxes as in the UK, Spain., Italy,
Greece, Ireland, Portugal etc
 The austerity view is that interest
rates should be raised, not cut, and
that monetary policy should be
tightened as advocated by the BIS
and for many, especially EMs by the
IMF
 That is where the debate rests today
(Aug 2011).
Both schools believe they are right
and that time will vindicate their view.
But there is more to it than that as the
debt crises have shown.
 Itis that the more govts borrow today
by running budget deficits the
worse the debt burden will become.
Rogoff and Reinhart in a much-
admired book have estimated that
once a countrys debt-to-GDP ratio
exceeds 90%, GDP growth slows by
one percentage point a year.
 The reflationists accept this, but say
that with growth very slow and
unemployment very high, the focus
today should be on growth.
Grow now cut later is their motto.
 This is what the Obama Democrats
are saying in the and left-wing
political parties in Europe.
So the divide is both about
economics who is right? and
politics, left (borrow and spend) and
the right (cut and raise interest rates).