The world is in its worst economic shape since the Great Depression. While it’s easy to lay the blame on Gordon Gekko-types, the meltdown is a bit larger than Wall Street. It’s now clear the past two decades of boom hid a Giant Global Imbalance two ends of whom were the US and China. It toppled over last year and the consequences continue today. A short, imbalanced history:
Problem: It all starts with the end of Yankee frugality. Over a 20-year period, Americans gradually stopped saving. By 2006, the US’s balance books were redder than a Trotskyite. Americans were pulling in about $800 billion a year from overseas to pay for their consumption.
Imbalance: Normally, this would have led the rest of the world to shy away from the dollar, thus forcing up US interest rates and curtailing American excess. It didn’t happen. Reason: China (see below).
Problem: Like other East Asian tigers, China has been exporting like crazy and making its people save like crazy. When Singapore does this, it’s a drop in the bucket. When a billion people do it, it generates an ocean of capital looking for places to invest.
Imbalance: All this capital should have driven up the renminbi’s value and helped reduce exports. Beijing didn’t allow. It hoarded the dollars, creating a foreign exchange mountain. Some of the dollars, mixed with Chinese savings, were directed into infrastructure and factories. Combined with an artificially low currency, this meant even more exports and more dollars.
Problem: What to do with a trillion-plus dollars in reserves? China financed US government debt. This kept US interest rates low and encouraged American extravagance. This became a vicious cycle: more US spending meant more Chinese exports which meant more US debt buying, which meant more US spending.
Imbalance: So long as Chinese lending matched US spending, this system — sometimes called Bretton Woods II — might have gone on for years. But a US-China imbalance became global (see below). And US spending became speculative (see below that).
Problem: The US wasn’t alone in overconsuming. China wasn’t alone in oversaving. Britain was an economic microcosm of the US. Oil-rich Gulf states, Germany and most emerging economies did some variation of China’s dollar-sucking. By 2008 emerging economies had a capital surplus of about $900 billion, well ahead of the US capital deficit.
Imbalance: The world was financially divided. One half let its credit markets finance spending gone mad. The other half fiddled their currencies or suppressed consumption to ensure dollars kept coming in. India did a bit of both and on a smaller scale, making it a bit more sure-footed than most.
What Might Have Been
Problem: As The Economist wrote, if all this capital had been invested in new technology this could have had a fairytale ending. But the dotcom bust put tech in the doghouse. Washingtonians focussed on using its share of the capital to pay for two wars, New York City focussed on real estate speculation. To top it all, central banker to the World Alan Greenspan believed markets would self-correct. But China wasn’t acting like a market economy. Its action had to be compensated by US regulatory action — and Greenspan didn’t act.
Imbalance: Cheap capital began flowing into US real estate. It mated with a belief new derivative instruments meant risk could be spread around the world and reduced to zero. This begat the subprime monster. As a senior IMF official said, “Subprime offered high returns, no risk. Amazingly, educated people fell for this.” By 2007, over $400 billion worth of US home buying was purely speculative. Owning two or three houses made Americans feel even richer, so they bought even more geegaws made in China.
Under all the present turmoil, the world economy may actually be rebalancing. The average American is spending less, saving more. China’s exports are crashing and Beijing is trying to stimulate domestic demand.
Readjustment is proving painful: Industries that did well out of US spending are sinking. Commodity economies like the Gulf states and Russia who boomed because of China’s export machine are in free fall.
Will a Great Global Balance emerge when the dust settles? Yes, but it won’t be easy. The US economy is 3.3 times larger than China’s, notes Michael Pettis of Peking University, so China would have to increase consumption by an impossible 40 per cent to balance the present US savings rate of 6 per cent of GDP. China, like most emerging economies, sees dollar reserves as family silver and won’t sacrifice them without a fight.
Looked at this way, the US’s attempt to hold up spending through stimuli and China’s determination to export are silly as both shore up the Great Global Imbalance. The truth is that it can’t be saved. All this stuff only softens the landing. The market will dictate a rebalance. It may be for the better. As economist Ed Yardeni of Yardeni Research argues, recessions are essential to a capitalist economy because they “purge the economy of speculative excesses.”
Warning: Even with the meltdown, the world is and will still be flush with capital. Post-World War II, only the US generated wealth. Today, there are a dozen centres of wealth creation. It seems strange to say so now, but the world had better start thinking of how to use all this excess money two years hence. What we don’t want is Uncle Sam pulling out his credit cards again. What we do want is capital into emerging economy infrastructure and new technology.