Which Way Forward?

Historically, large debt declines have been associated with prolonged high growth. As reviewed in IMF (2009) the post World War II recovery allowed public debt in Japan, the United Kingdom, and the United States to decline significantly after the steep, war-driven accumulation of debt. The comparison is not fully out of place as the fiscal cost of this crisis could end up being not far away from that engendered by the war.

A desirable scenario for the medium term would see a sustained and sustainable growth rate which could allow for gradual withdrawal of fiscal stimulus and a decline in debt ratios. This scenario would imply a gradual shift from a policy driven recovery to self-sustained growth and would require a return to the global growth rates witnessed in the exceptional period before the housing bubble burst. Such a scenario, however, could be overly optimistic for at least two reasons. First, it is unlikely that the growth mechanism prevailing before the outbreak of the crisis can be restored. Second, as a consequence of the recession, potential output growth could fall in some if not all economies. Let us look at these two aspects more closely.

The financial crisis mounted, and eventually exploded, in a macroeconomic framework that has developed over the past two decades and which is usually referred to as “Bretton Woods II” (Dooley, Folkerts-Landau, and Garber 2003). It can be summarized as follows. The main engine of growth in the international system has been US domestic demand, household demand in the first place, itself driven by increasing employment in a low inflationary environment. This was made possible by an exceptionally long period of sustained productivity growth, generated by the mechanism often referred to as the “new economy”, following the introduction and diffusion of information and communication technologies (Visco 2009). An increasingly unregulated financial system has acted as a very powerful multiplier and facilitator of this mechanism, by allowing households to consume in excess of income and leveraging on the (expected) value of their properties. With hindsight the financial crisis initiated in the mortgage market was the result of an endogenous mechanism which has gone through the “classic” phases of manias, euphoria, and panic. The history of financial crises is full of such events, all apparently different from one another yet all reflecting one mechanism. Bretton Woods II provided the specific, global, macroeconomic environment that led to euphoria first and crash afterwards.

This macroeconomic environment has generated a widening US current account deficit, matched by a surplus in emerging economies, the People's Republic of China's (PRC) in particular, whose exports have fed both US consumption and emerging markets' growth. In the PRC this has been facilitated by a fixed exchange rate between the dollar and the yuan (a de facto dollar peg) that protected competitiveness and boosted reserve accumulation. Reserves were largely reinvested in the US financial market. One relevant consequence of this is that the US financial system has enjoyed abundant liquidity, which has been accommodated by US monetary policy, in a context of rapid financial innovation (that has gone well beyond the mortgage market) and weak regulation and oversight. This, in turn, facilitated the growth and later bursting of the housing market bubble. The other advanced economies of Europe and Japan played “secondary” support roles. Both economies have suffered, and continue to suffer, from low potential growth, signaling the need for structural reforms, and both have been relegated to the back seat as engines of global growth.

The crisis has destroyed the fundamentals of the Bretton Woods II system and, in particular, the mechanism through which excess savings in emerging economies (including those of oil producing countries) were reinvested in the center of the system at “no risk,” as the US economy was considered the “safe haven” par excellence. The crisis has destroyed the credibility of the center and, with it, the main engine of growth and of financing of growth. The global economy is now going through the longest and deepest post-war, recession. The decomposition of the growth mechanism (“deleveraging”) is still unfolding at the time of writing. It is highly unlikely, if not outright unthinkable, that the main engine of global growth in the foreseeable future will be US household demand fueled by sophisticated and opaque financial instruments.

Growth will resume after the recession but it could be a lower potential growth. More importantly, global growth will be driven by several engines rather than by a single one and each of the engines will most likely be less powerful than the one that has collapsed and partly disconnected from the others. Household demand as a source of growth in the US will be partly replaced by exports, driven by a weaker dollar and by the still powerful US productivity engine, possibly augmented by important investment in new technologies. It remains to be seen whether US investment and innovation, themselves driven by the stimulus package, will be able to generate a productivity cycle as long and intense as the one that was supporting the “new economy” in the 1990s. It also cannot be ruled out that, as global value and innovation chains restructure, some centers of innovation and productivity will not relocate from the US to the emerging economies, especially those of Asia, thereby adding to their growth potential.

While the US economy may decline in size, if only in relative terms, it is hard to believe that the economies of Brazil, Russia, India, and the PRC will quickly emerge as global engines of growth. Long-term projections usually place the PRC (and less so India) as the largest economy 20 to 30 years from now. Most of these projections, however, extrapolate from a scenario which is no longer there and which needs to be rebuilt: a relatively stable world economy in which global markets are open, economic integration is progressing, and no major crises occur. It remains to be seen to what extent the current crisis will allow us to keep these assumptions alive. Whatever the case, sooner or later the emerging economies will have to face the challenge of their internal transformations that make more space for domestic demand and rely less on export-led growth. These transformations will need to be accompanied by, and possibly support, a sustained high rate of growth: a necessary condition for these countries to raise the standard of living for the large part of their populations that still live below the poverty line.

What about Europe? The old problems are still there and the financial crisis has made them more acute. Europe in Bretton Woods II has been a slow growth economy and it could grow even less in the future. As noted above, the extensive use of fiscal measures to deal with first the financial emergency and then the recession could have the effect of loosening fiscal discipline in Europe which will make long term debt sustainability more problematic. More flexibility in the application of the Stability and Growth Pact is welcome in the crisis but there is a risk that the credibility capital accumulated over the past decade could quickly vanish. Of further concern for the European economy would be the possible adoption of subsidies for non-financial industries, which would distort competition, combined with a weakening of structural reform and liberalization efforts, efforts which must rely upon sufficient amounts of political capital and fiscal space for their implementation. All of this could undermine the Single Market and European growth.

Fears of lower growth could be further reinforced if the recession lowers potential output in Europe and elsewhere. There are three main channels through which this could happen. First, a portion of the increase in the number of unemployed during the downturn could become irreversible. This can happen when workers lose attachment to the labor force and their skills atrophy during lengthy spells of inactivity. Consequently, it becomes more difficult for them to find employment once the recovery begins. In the wake of past recessions, labor input has been reduced through a combination of lower labor force participation and higher structural unemployment as negative shocks have interacted with inflexible labor markets. Second, steep reductions in investments by businesses and households are characteristic of most downturns. Investment is also likely to be lower following the crisis to the extent that the cost of using capital is higher, due, for instance, to larger risk premiums. During recessions investment often falls sharply and firms go out of business. This may accelerate the scrapping of capital or lead to its relocation, thus lowering the capital stock and/or its efficiency. Financial crises exacerbate these typical effects of recession by impairing financial intermediation, raising further the cost of capital, and forcing otherwise viable firms out of business. Finally, intangible investments, such as spending on research and development are among the first outlays that businesses cut back during a recession. The resulting impact on growth can be significant, because R&D is needed to sustain the discovery of innovations. In fact, the productivity gains of workers today are often in part the fruits of R&D outlays from a decade or more ago. Lower growth would also increase the debt burden.

The potential impact of the financial crisis on the level and growth rate of total factor productivity is more ambiguous. On the one hand, it may lower total factor productivity by reducing the R&D intensity of the economy as firms reduce such spending. On the other hand, recessions may lead to the closure of the least productive lines of activity and force the least productive firms out of business, thereby increasing average productivity across the economy.

Empirical studies suggest that potential output could be significantly reduced in the wake of the crisis. The average downward revision to the level of potential output made by various national authorities (Table 7 [ PDF 26.5KB | 1 page ]), is about 2.5% by 2010, which is close to the average of OECD revisions (Figure 7 [ PDF 18.2KB | 1 page ]). However, for some countries the revisions are much larger. The major contribution to the projected fall in near-term potential growth in the OECD revisions comes from the collapse of investment and the associated slower growth of capital input to production. However, the decline in capital intensity is likely to continue over the medium term in response to the increase in capital costs associated with an increase in risk aversion. In addition, the non-accelerating rate of unemployment may increase, particularly in European countries. As mentioned, in the wake of past recessions structural unemployment has tended to rise in many countries, which may partly reflect rising long-term unemployment and hysteresis-type effects. Past experience suggests that European countries may be more vulnerable than other countries to such effects.

Download this Paper [ PDF 296.4KB| 23 pages ].

Comment(s)

There are [0] comment(s) for this entry. Post a comment.