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Martin Wolf


The world economy has no easy way out of the mire

By Martin Wolf

Published: February 23 2010 21:49 | Last updated: February 23 2010 21:49


Anybody who looks carefully at the world economy will recognise that a degree of monetary and fiscal stimulus unprecedented in peacetime is all that is prodding it along, not only in high-income countries, but also in big emerging ones. The conventional wisdom is that it will also be possible to manage a smooth exit. Nothing seems less likely. So let us consider the endgame, instead.

We must start from the reverse side of the stimulus coin: the private sector is now spending far less than its aggregate income. Forecasts in the Organisation for Economic Co-operation and Development’s latest Economic Outlook imply that in six of its members (the Netherlands, Switzerland, Sweden, Japan, the UK and Ireland) the private sector will run a surplus of income over spending greater than 10 per cent of gross domestic product this year. Another 13 will have private surpluses between 5 per cent and 10 per cent of GDP. The latter includes the US, with 7.3 per cent. The eurozone private surplus will be 6.7 per cent of GDP and that of the OECD as a whole 7.4 per cent.

Moreover, the shift in the private sector balance between 2007 and 2010 is forecast to exceed 10 per cent of GDP in no fewer than eight OECD member countries (see chart). It is also forecast to exceed 5 per cent of GDP in another eight. In the US, it is forecast to be 9.6 per cent of GDP. In the eurozone, it is forecast at 5.5 per cent of GDP and in the OECD at 7.3 per cent. Depression threatened.


Note that such huge shifts towards frugality will have occurred, despite the unprecedented monetary loosening. While the latter helped prevent a still-greater collapse in private spending, the huge fiscal deficits, largely the result of automatic stabilisers, have been no less important. If governments had tried to close fiscal deficits, as they attempted to do in the 1930s, we would be in another Great Depression.

So how do we exit? To answer the question, we need to agree on how we entered. A big part of the answer is that a series of bubbles helped keep the world economy driving forward over the past three decades. Behind these, however, lay a credit super-bubble, which burst in 2008. This is why private spending imploded and fiscal deficits exploded.

William White, former chief economist of the Bank for International Settlements, is a leading proponent of the view that monetary policy errors, particularly by the Federal Reserve, have driven the world economy. Richard Duncan offers a similar, but more radical, critique in his thought-provoking new book, The Corruption of Capitalism.

At the 75th birthday conference of the Reserve Bank of India this month, Mr White gave a lucid version of his critique. With inflation kept down by supply shocks, inflation-targeting central banks kept interest rates too low too long. The result, he argued, was a series of imbalances, not dissimilar to those in the US in the 1920s and Japan in the 1980s. In particular, with the real interest rate well below the rate of growth of economies, the expansion of credit was effectively unconstrained. Debt duly exploded upwards (see chart).

Mr White pointed to four imbalances: asset price bubbles, notably of stocks in the 1990s and houses in the 2000s; the explosion of the balance sheet of the financial sector and increase in its exposure to risk; what “Austrian school” economists dub “malinvestment” – soaring consumption of durables in high-income countries and booming construction of housing and shopping malls in countries such as the US, and of export-oriented factories in China; and, finally, trade imbalances, with capital pouring into the US and other high-spending countries.

I do not agree that monetary policy mistakes were responsible for all of this. But they played a role. In any case, all this had to end. Now, after the implosion, we witness the extraordinary rescue efforts. So what happens next? We can identify two alternatives: success and failure.

By “success”, I mean reignition of the credit engine in high-income deficit countries. So private sector spending surges anew, fiscal deficits shrink and the economy appears to being going back to normal, at last. By “failure” I mean that the deleveraging continues, private spending fails to pick up with any real vigour and fiscal deficits remain far bigger, for far longer, than almost anybody now dares to imagine. This would be post-bubble Japan on a far wider scale.

Unhappily, the result of what I call success would probably be a still bigger financial crisis in future, while the results of what I call failure would be that the fiscal rope would run out, even though reaching the end might take longer than worrywarts fear. Yet the big point is that either outcome ultimately leads us to a sovereign debt crisis. This, in turn, would surely result in defaults, probably via inflation. In essence, stretched balance sheets threaten mass private sector bankruptcy and a depression, or sovereign bankruptcy and inflation, or some combination of the two.

I can envisage two ways by which the world might grow out of its debt overhangs without such a collapse: a surge in private and public investment in the deficit countries or a surge in demand from the emerging countries. Under the former, higher future income would make today’s borrowing sustainable. Under the latter, the savings generated by the deleveraging private sectors of deficit countries would flow naturally into increased investment in emerging countries.

Yet exploiting such opportunities would involve radical rethinking. In countries like the UK and US, there would be high fiscal deficits over an extended period, but also a matching willingness to promote investment. Meanwhile, high-income countries would have to engage urgently with emerging countries, to discuss reforms to global finance aimed at facilitating a sustained net flow of funds from the former to the latter.

Unfortunately, nobody is seized of such a radical post-crisis agenda. Most people hope, instead, that the world will go back to being the way it was. It will not and should not. The essential ingredient of a successful exit is, instead, to use the huge surpluses of the private sector to fund higher investment, both public and private, across the world. China alone needs higher consumption.

Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead.

martin.wolf@ft.com