30.11.2016

Can Advanced Nations Return to Rapid Growth and the World Avoid A New Global Financial Crisis? (Prof. D. Salvatore)

by Lantern Fund Forum

4001. Introduction

After nearly seven years from the end of the deepest global financial crisis of the postwar period, growth continues to be slow in advanced countries and falling in most emerging market economies. There is even the risk that the world may be drifting toward a new global financial crisis and even secular stagnation. These are the issues examined in this paper.         

2.  Growth Prospects in Advanced Nations

The recent global financial crisis started in the U.S. housing sector in 2007 as a result of banks giving huge amounts of (sub-prime) loans or mortgages to individuals and families that could not afford them. When many individuals and families defaulted on their loans, U.S. banks fell into a deep crisis, which then spread to the entire financial sector in 2008 and, from there, to the U.S. real sector and to the rest of the world economy. The result was the “Great Recession” (Salvatore, 2010 and 2014).

            Since the end of the 2008-2009 recession, the U.S. real growth rate averaged 2.1 percent per year (as compared with a yearly average of 3.0 percent in the decade before the recent crisis and recession) and is forecasted to be only 1.6 this year and 1.8 percent in 2017. Europe fared worse than the United States. Euro Area growth averaged only 0.8 percent from 2010-2015 (the Euro Area even fell back into recession in 2012-2013) and growth is forecasted to be 1.7 percent in 2016 and 1.5 in 2017. The situation was even worse in Japan (which was in recession in 2011 and 2014) and growth is now forecasted to be less than 1 percent this year and the next. Britain and Canada fared better than the Eurozone and Japan since the end of the crisis, with a growth rate comparable to that of the United States.

            While Europe and Japan would probably have been satisfied with the U.S. recovery and growth rate since the end of the recent recession, the United States is not. The reason is that the recovery was not rapid enough to bring the United States back on its long-run growth trend line, as it happened after all other postwar recessions. In fact, the U.S. recovery and the subsequent growth after the recent global financial crisis and recession was the slowest of the last six recessions that the United States experienced since the end of World War II. Despite the fall in the official unemployment rate from the high of 9.6 percent in 2010 to about 5 percent in 2015, the rate of underemployment (which includes also all marginally attached workers plus workers employed part time for economic reasons) was more than double the official unemployment rate and the ratio of the underemployment to unemployment rate was much higher in 2015 than in 2008. Only in April 2014 did the number of U.S. jobs return to their 2007 level, even though the total labor force has increased by over three million over the same period. This means that there were almost 3 million jobs "missing" in the United States at the beginning of 2016. Pressure on the U.S. labor market is also shown by the fact that the median the wage income grew at a much slower rate between 2010 and 2014 than in the previous two decades. Only in 2015 did  U.S. wages began to rise faster (Salvatore, 2016).           

The United States and other advanced nations responded to the "great recession" by rescuing banks and other financial institutions from bankruptcy, slashing interest rates, introducing huge economic stimulus packages, making very large injections of liquidity, and also undertaking heavy nontraditional expansionary monetary policy (quantitative easing or QE). More recently, the ECB, the Bank of Japan (as well as the central bank of several smaller advanced European countries) even introduced negative nominal interest rates. Such powerful expansionary monetary policy had been not even envisioned before the recent crisis. These efforts, however, only succeeded in preventing the recession from being deeper than otherwise and from making the subsequent recovery even slower than it actually was. Be that as it may, growth remained the most serious economic problem facing most advanced nations in 2016. Indeed, there is even the fear that the United States and other advanced countries may be facing secular stagnation (Gordon and Summers, 2015).

            There are several reasons for the recovery from the recent deep recession being so much slower than after previous recessions in most advanced nations. The most important was the sharp decline in labor productivity. In the United States, the average yearly productivity growth was only 1.1 percent between 2007 and 2015 as compared with 2.4 percent between 1999 and 2006. Comparable figures in percentages were 0.7 and 1.8 in Japan, 0.1 and 2.4 in the United Kingdom, 0.5 and 1.5 in the Euro Area, and 0.6 and 1.9 in the European Union of the 28 member countries (EU-28). Another important reason for slower growth after the last recession as compared to before the recession was outsourcing. Most multinationals from advanced nations, in their effort to minimize production costs, transferred a great deal of production and jobs to emerging markets, especially China, during the past decade. Growth was also discouraged in advanced nations by high taxes and policy uncertainty. Overregulation and an excessive welfare state was another reason, especially in Europe. Japan has had an even worse growth record than Europe and much worse than the United States. Indeed, Japan suffered 6 recessions during the past twenty-five years and its growth is forecasted to be only 0.5 percent this year and in 2017.

            Tired of excessive EU regulations and immigration, the United Kingdom voted for Brexit on June 23, 2016. This was unexpected by most economists in the United Kingdom and abroad because calculations just before the vote showed that Brexit would impose high economic burdens on the United Kingdom. Immediately after the vote U.K. economic growth forecasted was sharply revised downward, financial markets exhibited strong volatility, and the stock market and the pound sterling fell sharply. These negative effects, however, soon subsided (except for the depreciation of the pound) but the Bank of England (BoE) lowered its benchmark rate to the lowest level in the BoE's 322-year history) and also resumed QE to avoid a possible recession. Nevertheless, significant negative effects on the United Kingdom are forecasted in the years to come primarily as a result of the reduction in the inflow of foreign direct investments, immigration and skills, and in the importance of London as Europe's premier  financial center. Factored in these negative estimates are the positive effect of increased exports as a result of the depreciation of the pound sterling as well as the stimulus to growth resulting from the additional deregulation that the United Kingdom would be able to undertake with Brexit (however, since the United Kingdom is already much less regulated than the other EU members, the benefit of further deregulation with Brexit may not be very large).  

            The actual size of the negative effects on the United Kingdom and (by repercussion) on the rest of Europe and the world will depend, however, on how the United Kingdom manages Brexit and how the rest of the world (primarily the European Union) responds to it. Perhaps, the best deal that the United Kingdom can negotiate with the European Union is to remain part of the European Economic Area (EEA) upon exiting the European Union. This is often referred to as the Norway Case or "Brexit soft", whereby the United Kingdom would retain full access to the European Union, while continuing its financial contribution to the European Union (but with no say in how EU rules are set) and continuing to uphold the EU's four freedoms (the free flow of trade, services, capital, and labor). The European Union will accept no less as a condition for the United Kingdom to be a member of the EEA. Since one of the primary reasons for Brexit was to limit immigration, the United Kingdom may have second thoughts about leaving the European Union (despite Prime Minister Theresa May's statement that "Brexit means Brexit") after carefully re-evaluating the benefits and costs of Brexit.  

 

3.  Growth Prospects in Emerging Market Economies

The recent economic crisis in emerging market economies started as a result of contagion as the recession-afflicted advanced nations sharply cut imports from and the flow of investments to emerging market economies. This was one reason for the decline in China's previous spectacular growth. While India's growth held up, most other large emerging market economies (Russia, Turkey, Mexico, and Brazil) faced deep recession after the global financial crisis.

            The slowdown in China's growth rate, however, was even more the result of its effort to restructure the economy toward more internal demand and a service economy rather than relying as in the past on continued export growth and on heavy domestic investments (the former because it was no longer sustainable and the latter because of the setting in of the dreaded diminishing returns). In the process, China's demand for primary commodity imports from other emerging market economies (especially Brazil and many African countries) declined sharply. This caused an even greater growth slowdown in other emerging market economies than the decline resulting from the recession in advanced countries.

            As the demand for their primary exports declined, the currencies of emerging market economies sharply depreciated or were devalued, thus making the servicing of their previously large accumulated financial debt and dollar borrowings unsustainable. Brazil is facing deep recession, with a decline of its real GDP expected to be as much as 3.8% in 2016. Russia, of course, faced even more economic difficulties in 2015 as a result also of  wars and the economic sanctions that it faced.

            The economic crisis in most emerging market economies would have even been deeper, however, had these nations not been operating under some form of exchange rate flexibility or had not devalued their currencies (which cushioned to some extent their reduction in exports) and had they not entered the crisis with more foreign exchange reserves accumulated during the commodity boom of the previous decade. Nevertheless, most emerging markets are also facing lower growth rates that during the past decade.

 

4.  Is the World Facing a New Global Financial Crisis?

A global financial crisis occurred in 1987, 1992, 1997, 2001, and 2008. With five crises in nearly 30 years (one crisis on a average every six years), the world seems to be due for another crisis soon. With nominal interest rates near zero in the United States, Britain and Canada and negative in Japan, the Euro Area (and Denmark, Sweden and Switzerland), investors, in a desperate search for returns, are undertaking "excessively" risky investments. How else can be explained the 40 percent rise of the Brazilian stock market (SP Bovespa) from January to October 2016? Thus, Brazil -- a country in deep recession, with an unsustainable budget deficit and national debt, and a dangerous political problem -- has had the best performing stock market in the world!  

            All it could take is even a small increase in the Fed policy rate to trigger a huge capital outflow and plunge Brazil in an even deeper economic crisis. The same could happen to other emerging market economies that are heavily indebted in dollars, and this could then trigger for a new world-wide financial and economic crisis. A new global crisis could also arise from a hard landing in China as a result of the bursting of its huge housing bubble and unsustainable corporate non-financial debt (that has now reached over 150 percent of its GDP). While we know that a new financial bubble is arising, no one can predict when a new crisis (like an earthquake) will actually occur. The trigger could be an event that under normal circumstances would not be very serious.

 

 5.  Is Slower World Growth or Even Secular Stagnation Inevitable?

Even without a new global financial crisis, is the world now facing generally slower growth than during the past decade? As we have seen above, the main reasons for the slow growth in advanced nations after the global financial crisis was the slowdown in the growth of labor productivity. Governments are attempting to reverse this situation by improving social and physical infrastructures (education, technical training, telecommunications, transportation, etc.). To the extend that the slowdown in economic growth is also due to overregulation, the cure, of course, would also be to deregulate. But this has been difficult to do, especially in Europe and Japan, and increasingly so in the United States.

            After their spectacular growth during the past decade (Klein and Salvatore, 2013), emerging markets are also facing slower growth because of (1) the rapid slowdown in population growth and in the growth of their labor force, (2) the convergence hypothesis (which postulates that is it easier to grow starting from a very low base when there are many technologies still available to be copied or adapted than later on), (3) the related "middle-income trap" (i.e., the difficulty often experienced by emerging market economies taking off to reach advanced-economy status), and (4) in today's highly interdependent world, because a slowdown of growth in advanced countries would inevitably lead to a slowdown in the growth of emerging economies also (and vice-versa).

            Most emerging economies need to restructure their economies away from excessive reliance on exports of primary commodities and toward their service and manufacturing sectors, so that more of their future growth can be generated endogenously rather than them relying so much on commodity exports. Many emerging markets, however, have not taken advantage of the commodity boom of the previous decade to restructure their economies, and now that they are in a crisis they do not have the resources to do so. Furthermore, and as China is finding out, economic restructuring is not easy to carry out because it can lead to a further slowdown in growth during the restructuring process, as the restructuring costs are incurred up-front while the benefits come only gradually over time.

            A minority of economists believe that the most serious problem facing the world economy today is not just the risk of another global financial crisis or even slower growth but, more ominously, it is the danger of downright secular stagnation in advanced nations and growth recession in emerging (Gordon and Summers, 2015). These economists believe that the only way to avert secular stagnation would be by a coordinated, massive injection of public expenditures (fiscal stimulus) on a global scale directed at building and repairing infrastructures. These are supposed to increase productivity and growth, and to pay for themselves. Japan, however, has actually tried this during the past two decades to no avail -- its debt is now almost 250 percent of GDP and its average growth rate has been below 1 percent per year. And, wound markets continue to finance larger and larger national debts at reasonable rates indefinitely? It has been estimated that for each one percent increase in the interest rate, the United States would require an additional $100 billion dollars to service its debt! 

           

6.  Conclusion

After six years from the end of the deepest global financial crisis of the postwar period, growth continues to be slow in most advanced and falling in most emerging market economies. There is even the risk that the world may be drifting toward a new global financial crisis in the short run and slower growth or even secular stagnation in the long run. There are conflicting opinions as to the validity of these projections and expectations, as well as on to how best to respond to reverse slowing world growth or secular stagnation, if indeed those expectations will come to pass.

References

Gordon, R. J. (2015).  "Secular Stagnation: A Supply-Side View". American Economic Review Papers and Proceedings, 105 (5), pp. 54-59.
IMF (2016), World Economic Outlook (Washington, D.C.: IMF, October).
Klein, L. and Salvatore, D. (2013). "From G-7 to G-20". Journal of Policy Modeling, 35 (3), pp. 416-424.   
OECD (2016), Economic Outlook (Paris: OECD, November.
Salvatore, D. (2010). "Causes and Effects of the Global Financial Crisis". Journal of Politics and Society, 21 (Spring), pp. 7-16.
Salvatore, D. (2014). Editor, Rapid Growth or Stagnation for the U.S. and the World Economy? Special Issue of the Journal of Policy Modeling, 36 (4).
Salvatore, D. (2016). "Slow Recovery and Growth Prospects for the United States." Special Issue of the Journal of Policy Modeling, 38 (4), pp. 624-631.
Summers, L. H. (2015). Demand side secular stagnation. American Economic Review Papers and Proceedings,105 (5), pp. 60-65.

 Dominick Salvatore is Distinguished Professor of Economics, Director of the Ph.D. Program in Economics at     Fordham University in New York City and Director of the Global Economic Policy Center. He is Honorary Professor at the Shanghai Finance University, Nanjing Finance and Economics University, Hunan University, and University of Pretoria; Visiting Professor at various universities, including University of Rome, American University in Cairo, University of Pretoria, Peking University, University of Trieste, and University of Vienna. Dr. Salvatore is a Fellow of the New York Academy of Sciences and past Chairman of its Economics Section. He is also the past president of the North American Economic and Finance Association (NAEFA) and the International Trade and Finance Association (ITFA). He is a Consultant to the United Nations, the World Bank, the International Monetary Fund, the Economic Policy Institute, and several multinational corporations and global banks. He is the co-editor of the Journal of Policy Modeling and past co-editor of Open Economies Review and The American Economist, as well as past Editor of the Handbook Series in Economics, Greenwood Press. He has given more than 600 lectures around the world, was awarded the Achievement Award by the City of University of New York in 1997, the Order of the Knights of Malta, and was nominated for the 2010 National Medal of Science awarded by the President of the United States. Dr. Salvatore is the author of leading textbooks on International Economics, Managerial Economics, and Microeconomics. In all, he has published 58 volumes. Web: www.fordham.edu/economics/salvatore.

 


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