Transcript Slide

The Global Economic Situation
Jeffrey Frankel
Harpel Professor of Capital Formation and Growth
China Future Leadership Project
Feb.3, 2009
1
Topics
1.
How a US financial crisis turned global recession.
1.
2.
3.
4.
5.
6.
2.
Origins
US recession
Policy response: monetary, banking, fiscal
Spread to the rest of the world
Forecasts
Emerging markets
The longer-term problem of US-China symbiosis
1. US deficiency of national saving
2. The RMB and complaints from US politicians
3. Will the $ stay the top international reserve currency?
2
The return of Keynes
Most economists still shy
away from using the name.
 But Keynesian truths abound today:

– Origins of the crisis
– The Liquidity Trap
– Fiscal response
– Motivation for macroeconomic intervention:
to save market microeconomics
– International transmission & coordination
3
Origins of the Crisis
 At
Davos last week, the leaders of
China and Russia chastised the
United States for having been the
source of the global recession,
 in fitting retaliation for lectures from
the US leaders ten years ago, to
emerging market governments, that
they should emulate the US financial
system.
4
Onset of the crisis

Well before 2007,
there were danger signals in US:
– monetary policy too easy 2003-04…
– flawed corporate governance
– underestimation of risk
– housing prices too high,
– National Saving low,
– current account deficit,
– excess leverage,
– imprudent mortgages…
5
Origins of the crisis
The crisis was a burst asset bubble,
loss of confidence, credit crunch.
 More like Keynes’ animal spirits
or beauty contest
than like Friedman-Schwarz

It was not a monetary contraction in
response to inflation (as were 1980-82 or 1991).
 But, rather, a credit cycle: 2003-04 monetary
expansion showed up only in asset prices.

6
Onset of the crisis

Initial reaction to troubles:
– Reassurance in mid-2007: “The subprime mortgage
crisis is contained.”
It wasn’t.
– Then, “The crisis may stay on Wall Street, sparing
Main Street.”
It didn’t.
– Then de-coupling :
“The US turmoil will have less effect on the rest
of the world than in the past.”
It hasn’t.
 By
now it is clear that the crisis-turnedrecession is as bad abroad as in the US.
7
US Recession
In December 2008, the NBER Business
Cycle Dating Committee proclaimed the
US peak had occurred December 2007.


Recovery unlikely before late 2009.
– Housing starts at record lows.
– Confidence at record lows…
=> Recession is longest since 1930s.
 Could well be as severe as 1980-82.

8
BUSINESS CYCLE REFERENCE DATES
Peak
Trough
Quarterly dates are in parentheses
August 1929(III)
May 1937(II)
February 1945(I)
November 1948(IV)
July 1953(II)
August 1957(III)
April 1960(II)
December 1969(IV)
November 1973(IV)
January 1980(I)
July 1981(III)
July 1990(III)
March 2001(I)
December 2007 (IV)
Average, all cycles:
1854-2001
March 1933 (I)
June 1938 (II)
October 1945 (IV)
October 1949 (IV)
May 1954 (II)
April 1958 (II)
February 1961 (I)
November 1970 (IV)
March 1975 (I)
July 1980 (III)
November 1982 (IV)
March 1991(I)
November 2001 (IV)
(32 cycles)
1945-2001 (10 cycles)
Source: NBER
Contraction
Peak to Trough
43
13
8
11
10
8
10
11
16
6
16
8
8
17
10
9
US employment peaked in Dec. 2007,
which is the most important reason why
the NBER BCDC dated the peak from that month.
Since then, 2 ½ million jobs have been lost.
Payroll employment series Source: Bureau of Labor Statistics
10
Recession was soon transmitted
to rest of world:

Contagion: Falling securities
markets & contracting credit.
– Especially in those countries with weak fundamentals:
Iceland, Hungary & Ukraine…
– But even in some where fundamentals were relatively
strong: Korea…

Some others are experiencing their own housing
crashes: Ireland, Spain…

Recession in big countries will be transmitted to all
trading partners through loss of exports.
11
Forecasts
12
OECD forecasts showed its growth approx. flat in 2009
Source: OECD
Economic Outlook
(Nov. 2008).
13
Similarly, World Bank forecasts showed
rich-country growth flat in 2009.
2006 2007 2008* 2009† 2010†
World
Memo item:
World
4.0
3.7
2.5
0.9
5.0
4.9
3.6
1.9
3.9
(PPP wts)
3.0
High-income countries 3.0
2.6
1.3
0.1
2.0
Developing countries 7.7
7.9
6.3
4.5
6.1
•Estimated
(% change from previous year)
† Projected
Source: World Bank, Jan. 2009
14
have now downgraded again
(Jan.28, 09)
15
The IMF has revised growth estimates for China
(Jan.28, 09)
& Russia sharply downwards as well.
Rev. vs.
2009
Oct.08
projection
16
All large countries in recession
 Bank
of Japan now expects to
contract (1/23/08):
– By 1.8 % in year ending March 2008,
– and by 2% in the coming year.
 Euro. Comm. :
EU growth = -1.8% in 2009.
(19 Jan.,09)
 China’s growth rate probably down by
half.
17
Policy Responses

Monetary easing unprecedented,
appropriately. But it has largely run its course:
– Policy interest rates ≈ 0.
(graph)
 The famous liquidity trip is not mythical after all.
– As Krugman & others warned us in re Japan in 90s.
 & lending, even inter-bank, builds in big spreads
– since mid-2007, not just since September 2008.

(graph)
Now quantitative easing, as the Fed continues
to purchase assets not previously dreamt of.
18
Policy rates have been cut most of the way to zero.
US
€
Japan
19
Bank spreads up
when sub-prime mortgage crisis hit (Aug. 2007)
and up again when Lehman crisis hit (Sept. 2008).
Source:
OECD Economic Outlook
(Nov. 2008).
20
Corporate spreads
between corporate & government benchmark bonds
zoomed after Sept. 2008
US
€
21
Policy Responses,
 The
continued
TARP keeps evolving
 First unspecific,
 then to buy toxic loans,
 then to recapitalize banks,
 then auto bailout,
 Now up in the air:
– insure banks’ toxic assets rather than acquire them?
– create “bad bank” as in “Swedish model”?
– outright nationalization not yet under consideration in US.
22
Policy Responses,
 Unprecedented
continued
US fiscal expansion,
most of which is still to come.
– Obama proposed an $825 expansion
– House passed a version. Senate will soon.
– Good old-fashioned Keynesian stimulus
 Even the belief that spending provides
more stimulus than tax cuts has returned
– not just from Larry Summers, for example,
– but also from Martin Feldstein.
23
Motivation for macroeconomic intervention

The view that Keynes stood for
big government is not really right.
– He wanted to save market microeconomics from
central planning, which had allure in the 30s & 40s.

Some on the Left today reacted to the crisis &
Obama’s election by hoping for a new New Deal.
– My view:
faith in unfettered capitalist system has been
shaken with respect to financial markets, true;
but not with respect to the rest of the economy;
– Obama’s economics will be centrist, not far left.
24
International transmission
 As
noted, international
transmission remains powerful
– Despite floating exchange rates
– Consistent with old-fashioned Keynes-MeadeMundell-Fleming transmission via trade balances.
25
Global Current Account Imbalances
will probably now be forced to adjust

US deficit will likely diminish,
– though adjustment requires $ depreciation.

Who must take corresponding
reduction in current account surpluses?
– Europe says: “Not us. Overall we are in balance.”
– Others say: Europe can expect to take a share,
roughly proportionate to its share in world trade,
– IMF seems to think oil exporters will take all adjustment
(see graph)
26
Current account adjustment:
US vis-á-vis oil exporters
(as % of GWP;
source: IMF)
27
But the OECD sees the €-area bearing almost as
much of the adjustment as non-OECD countries.
Source: OECD Economic Outlook, Nov. 2008.
3/ as % of GDP
28
Fiscal expansion internationally
 EU
agreed 1.5% GDP expansion in
Dec.
 Most other countries as well
 China:
– the most obvious candidate for fiscal
expansion.
– Beijing announced RMB 4,000 billion ($585 b) in
Dec.
 It sounds big. Is it?
– Fiscal expansion & development of health
29
International coordination
of fiscal expansion?
As in the classic Locomotive Theory

Theory: in the Nash non-cooperative equilibrium
each country fears expanding fiscally for fear of
adverse trade deficit.
– Solution: A bargain where all expand together.

In practice: example of Bonn Summit, 1978
– didn’t turn out so well,
– primarily because inflation turned out to be a bigger problem
than realized (& German world was non-Keynesian).
– That is less likely to be a problem this time.
30
Emerging Markets
31
3 cycles of net private capital flows
to emerging markets, by region
peaking in 1982, 1997 and 2008
Source: Capital Flows to Emerging Market Economies, IIF, Jan.27 2009.
32
Capital flows to emerging markets
peaked in 2007
from: EM Fund Flows, Citi, December 200833
The Financial Crisis
Hit Emerging Markets in Late 2008:
Stock markets plunged and interest rate spreads rose
Source: IMF WEO, Oct. 2008
34
Among the “BRICs,” only China’s
capital account has improved lately
35
In mid-2008, foreign funds turned
bullish on China and bearish on Russia
36
What characteristics help an
emerging market economy resist
financial contagion?
High export/GDP ratio
 High FX reserves and/or floating currency
 Low foreign-currency-denominated debt
 Low short-term debt
 High Foreign Direct Investment
 Initially strong budget, allowing room to
ease.

37
The unsustainable
US saving shortfall
38
Downward trend in US trade deficit
1960-2006
Trade & Current Account Balances
2.00%
as Percentages of GDP
1.00%
0.00%
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
1960
1963
1966
1969
1972
1975
1978
1981
Trade Balance as % of GDP
1984
1987
1990
1993
1996
Current Account Balance of % of GDP
1999
2002
2005
39
“Mainstream” View of
Origins of US Current Account deficits

Deficits affected by exchange rates & growth rates.
– And indeed US TB has shown some improvement
2006-08, in response to $ depreciation & US growth
slowdown.

More fundamentally,
the US CA deficit reflects shortfall in National Saving
– US current account deficit widened rapidly in early 80s
& 2001-05, associated with falls in National Saving.
40
The US Current Account deficit originates
in a National Saving shortfall,
which in turn includes both
a rise in the Budget Deficit
& a fall in Household Saving.
41
Net National Investment, Saving &
Current Account, as shares of GDP
(%)
Figure 23.2. U.S. National Saving, Investments and Current Account
17.0%
12.0%
7.0%
2.0%
-3.0%
Net Natl Saving (% of GDP)
Net Domestic Investment (% of GDP)
Current Account (% of GDP)
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
-8.0%
42
Two global problems (US deficits &
emerging market boom) came together
in 2003-2007

The US balance of payments deficit financed
by the People’s Bank of China, and other
central banks & Sovereign Wealth Funds in
Asian & oil-exporting countries.

Can this mutual co-dependency arrangement
continue ?
43
Bretton Woods II: “China’s development strategy
entails accumulating unlimited dollars.”
Deutschebank view (Dooley, Folkerts-Landau, & Garber…):
 Today’s system is a new Bretton Woods, with Asia
playing role that Europe played in 1960s.
 That much is right.
 DFL ideas were original:

– China piles up $
not because of myopic mercantilism,
– but as part of an export-led development strategy
that is rational given China’s need to import
workable systems of finance & corporate governance.
44
But it is not sustainable.

It may be a Bretton Woods system,
but we are closer to 1971 (date of collapse)
– than to 1944 (date of BW agreement)
– or 1958 (when convertibility was first restored).
45
US politicians focus on the bilateral trade deficit,
US politicians focus on the bilateral trade deficit,
despite
ofeconomic
economic
importance.
despiteits
its lack
lack of
importance.
46
If China gave US politicians
what they say they want...

We might regret it.
– especially if it included reserve shift to match
switch in basket weights away from $.

US TB & employment wouldn’t rise
– fall in US bilateral trade deficit with China
would be offset by rise in US bilateral deficit
with other cheap-labor countries,

but US interest rates probably would rise.
– possible hard landing for the $.
47
48
The RMB
I agree with a majority of economists that
– RMB appreciation is in everyone’s interest.
– The movement vs. the $ since 2005 does not
constitute sufficient flexibility.
 But on the other hand,
– I do not agree that China’s $-link should be labeled
“manipulation in violation of international
agreements”; and
– Higher priority should be placed on expansion of
domestic demand, and structural shift from
manufacturing to services,

especially health, education, pensions.
49
A global cooperative deal

A global cooperative deal would simultaneously
appreciate the RMB & other currencies of Asians &
oil-exporters, while the US raised national saving.

IMF could broker the deal.
China & US will not be dictated to.
But in a $ crisis -- if US stands to lose the best
customer for its T bills, and China stands to lose the
best customer for its goods – both may see the
advantages of a deal.
China would admit that it has not already fixed its
currency, and that domestic demand also needs to be
increased. US would admit that it has a budget
deficit problem, and that the trade deficit is not
China’s fault.



50
The US & $ have had special roles in global
monetary system for more than 60 years.

“Exorbitant privilege” of funding US current account
(or basic balance) deficits by borrowing in dollars

As a safe haven, US has
benefited from flight to quality

Dollar as number one international currency
– #1 reserve currency in central bank holdings
– other functions: invoicing trade & financial flows, etc.

But the euro is now a credible rival
– Chinn & Frankel (2007, 2008)
– The dollar’s special role could come to an end.
51
Chinn & Frankel (2008) simulation
Figure 7: Only accession countries join EMU in 2010, (UK stays out) but
20% of London turnover counts toward Euro area financial depth, and
currencies depreciate at the 20-year rates experienced up to 2007.
€ passes $ around 2015
.8
.7
USD
.6
EUR
forecast
.5
USD forecast
.4
.3
DEM/EUR
.2
.1
.0
1980
1990
2000
2010
2020
2030
52
2040
The 2007-08 financial crisis has
probably further undermined the US
position in the long run
US financial institutions have lost credibility
 Expansionary fiscal and monetary policy may
show up as $ depreciation in the long run.
 The long slow decline of the $ as an
international reserve currency may
accelerate.

53
In the short run, however, the financial
crisis has caused a flight to quality which
apparently still means a flight to US$.
US Treasury bills are more in demand than
every, as reflected in very low interest rates.
 The $ appreciated in 2008, rather than
depreciating as the “hard landing” scenario
had predicted.
 => The day of reckoning has not yet arrived.

54
55