Brad Setser

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A large, truly global slump

by Brad Setser
February 13, 2009

China’s GDP growth stalled in the fourth quarter, which represents an enormous deceleration from its typical fast growth.

US GDP fell at a close to 4% annualized rate in the fourth quarter. The decline would have been steeper but for a big buildup in inventories. That will subtract from growth in q1.

Japanese GDP growth fell by around 10%. Some estimates are now even putting the q4 fall, annualized, at close to 12%. The fall in smaller Asian economies was often even larger.

And now we know that Europe’s GDP fell by 1.5% q/q, or 6% annualized. Germany, until recently Europe’s strongest economy, contracted at an 8% annual rate.

According to the European Union’s statistics office, the economy of the 16 countries sharing the euro currency declined by 1.5 percent in the fourth quarter. On an annualized basis, that would indicate a contraction of 6 percent — considerably deeper than the 3.8 percent annual rate of decline in the American economy in the same quarter. The performance was worse than many economists had expected, and it was even more pronounced in Germany, the euro zone’s most important economy. There, the economy shrank by 2.1 percent from the third quarter, when it had already contracted by 0.5 percent.

There is a lot of spare capacity in the global economy now.

Back in the 1990s, the vogue was to talk of capital account crises. A “sudden stop” in capital flows to an emerging economy triggered big fall in output; countries that relied on capital inflows to cover their external deficits had to bring their imports down suddenly — and that usually meant a sharp economic contraction.

It consequently is striking to me that the countries with the steepest falls in output in q4 have been the countries that are known for relying heavily on exports for growth —

They in effect are suffering from a sudden stop in global demand, which has given rise to a sudden stop in trade flows. Or perhaps a sudden stop in finance led to a sudden stop in demand, a sudden stop in trade and sharp falls in output.

Last summer — in Sovereign Wealth and Sovereign Power — I worried about the risk that China, or another major sovereign creditor, might stop financing the US if the US adopted policies its creditors opposed. As a borrower, the US was vulnerable to a sudden interruption in capital flows. I was implicitly drawing on the analogy of the emerging market crises of the 1990s.

It turns out though that — with a big enough shock — the volatility in output that can arise from a current account shock can be almost as big as the volatility from a capital account shock. Economies that relied on exports for growth weren’t invulnerable to external shocks. They just weren’t as vulnerable to capital account shocks …

The US took a risk by relying so heavily — for a time– on China’s government for financing. China likely bought about $400b of US debt in 2008, a non-trivial sum. But China took a risk by relying so heavily on American and European households for demand. Since these households relied on credit t maintain a high level of spending, China was exposed to a US banking and financial crisis.

Asian nations responded to the crises of the 1990s by taking a slew of steps to reduce their vulnerability to capital account crises, but in the process increased their vulnerability to “current account crises.” Their economies became more dependent on exports, and more of their exports came from countries whose external and internal finances looked a bit shaky …

One big question going forward is how will Asian nations try to reduce their vulnerability to crisis that come from the current account ….

118 Comments

  • Posted by MakeMeTreasurySecretary

    RebelEconomist,

    I am in agreement that standards of living will have to go down, in a way, in the Western World and particularly the USA. However, assume I have a house in the suburbs and two SUVs, my daughter is in Yale, and I pay for my son’s health care. I review my finances and I realize I must make major changes since I cannot afford this lifestyle. I am quite willing to make the transition. But in the USA, it is practically impossible to find an inexpensive condominium near public transportation, good schools, and inexpensive health care. The good life in America means paying a ton of money. Not as much in European and Asian countries, or in America 40 years ago.

  • Posted by Cedric Regula

    Came across this unbelievable tidbit in John Mauldin’s latest e-mail newsletter. The euro hasn’t got a chance against the The Trojan.

    ======================================

    “But European banks may be in far worse shape. Bruno Waterfield of the London Daily Telegraph reports to have seen an eyes-only document prepared by the European Commission for the finance ministers of the various EU member countries. The problem revealed in the report is an estimated write-down by European banks in the range of 16 trillion pounds, or about $25 trillion dollars! The concern is that bailing out the various national banks for such an unbelievable amount would push the cost of government borrowing to much higher levels than we see today.

    As my kids would say, “Really, Dad, you think so?” Europe is somewhat larger than the US, so think what my gold-bug friends would say if the US decided to borrow $25 trillion to bail out US banks. The dollar would be crucified! The euro is going to get a lot weaker if bank problems are even half of what the report says they are. The British pound sterling is already off almost 30% and, depending on what the real damage is to their banking system, it could get worse.

    Waterfield reports, “National leaders and EU officials share fears that a second bank bail-out in Europe will raise government borrowing at a time when investors — particularly those who lend money to European governments — have growing doubts over the ability of countries such as Spain, Greece, Portugal, Ireland, Italy and Britain to pay it back.

    “The Commission figure is significant because of the role EU officials will play in devising rules to evaluate ‘toxic’ bank assets later this month. New moves to bail out banks will be discussed at an emergency EU summit at the end of February. The EU is deeply worried at widening spreads on bonds sold by different European countries.”

    Part of the problem is that European banks were far more highly leveraged than US banks. Some banks were reportedly leveraged 50:1. And they lent money to Eastern European projects and businesses which are now facing severe financial strain and plummeting local currencies.

    Let that number rattle around in your head for a moment: $25 trillion. Even $5 trillion would be daunting. But the problem is that Europe does not have a central bank that can step in and selectively save banks from one country without taking on all euro zone member-country banks. Yet, as noted above, some countries may not have the wherewithal to save their own banks. It is reported that some Austrian banks are hoping that Germany will step in and help them. Given Germany’s problems, they may have a long wait.”

  • Posted by Albion

    Quiet many rumors at distressed time !
    It would be reassuring should the exposure in Eastern countries be the exclusive of european banks, though some like HSBC have a worring leverage when earmarking its own funds with its non performing assets.
    Bloomberg
    Several western banks asked about holding discussions,” Anatoly Aksakov, head of the association, whose 450 members include Citigroup Inc.’s Russia unit, Alfa Bank and VTB Group, said in an interview. “It was their initiative to have talks on this topic to look at restructuring the debts of several companies, so that everyone can be calm.”

    Banks such as London-based HSBC Holdings Plc suggested meetings with Russian companies concerning their ability to meet obligations, said Aksakov, who is also a lawmaker in the lower house of parliament. Less than $100 billion of international debt, $15 billion of which is due this year, may need to be restructured, he said.

  • Posted by Twofish

    MakeMeTreasurySecretary writes: I am in agreement that standards of living will have to go down, in a way, in the Western World and particularly the USA.

    I’m not. I don’t see any basic resource limitations, and if it’s a matter of finance, well we just change the numbers.

    MakeMeTreasurySecretary writes: However, assume I have a house in the suburbs and two SUVs, my daughter is in Yale, and I pay for my son’s health care. I review my finances and I realize I must make major changes since I cannot afford this lifestyle.

    I suggest that you should be mad as hell then. Over the last years we’ve seen huge increases in productivity and the richest 1% of the United States are making huge amounts of money fromm these productivity gains.

    They were able to justify these salaries, with the idea that the wealth would trickle down. If it isn’t then something is very wrong, and nothing is going to change unless people get mad as hell and start holding politicians and economic leaders accountable.

  • Posted by RebelEconomist

    Twofish,

    You don’t see any resource limitations? How about oil, food, fish, CO2 carrying capacity etc, etc? Granted, technology in the past has circumvented such limits to growth, but the world has never previously faced a challenge like 1.3bn aspiring Chinese before.

    I am not sure whether the Gordon etc debate about the US treatment of quality improvements settled, but I was always a bit sceptical of the US productivity “miracle”.

  • Posted by don

    ReformerRay responds:
    “Also, the ubiquity of export oriented economies in Asia make me wonder if cultural influences make this model in Asia particularly resistant to change”.
    “We see export oreiented economies in Asia simply because Japan proved that to be the road to wealth.”
    I think this is true.
    RR, RE and HR: We don’t need lower wages to get balanced trade, and there is no good reason that trade should be balanced, either multilaterally or bilaterally. That is, there is no reason to disallow net internaitonal lending. However, right now we have a global deficiency in demand, and policies to artificially domestic saving (currency interventions to deflate the local currency) are counterproductive and damaging to the global well-being. Yet, I fear that this will be the response of Asian countries to the current downturn.
    MMTS Very funny quip about rifles and economists.

  • Posted by Twofish

    don: “We see export oreiented economies in Asia simply because Japan proved that to be the road to wealth.

    This is hardly the case at all. Japan became an industrialized nation in the late-19th and early-20th century, and the economic model that it used was not particularly export driven.

    A focus on exports helped Japan and Germany rebuild after World War II, but Japan was already a very industrialized nation pre-WWII. Also the export focus of Japan and Germany had a political element in that by making Japan and Germany dependent on export markets, it would help insure that they would be unable to conduct either an independent foreign policy or a pro-Soviet one.

    China is not Japan. Export industries can only be a relatively small part of Chinese industrialization.

  • Posted by Twofish

    RebelEconomist: You don’t see any resource limitations? How about oil, food, fish, CO2 carrying capacity etc, etc?

    If you go through the list then none of them present any fundamental barriers to growth or standards of living. It might change some of the way that people live (i.e. bye bye suburbia, hello NYC), you can find ways of having high standards of living within resource constraints.

    RebelEconomists: but the world has never previously faced a challenge like 1.3bn aspiring Chinese before

    Followed by 1.3 billion Indians and 1.5 billion Africans.

  • Posted by Twofish

    don: . However, right now we have a global deficiency in demand, and policies to artificially domestic saving (currency interventions to deflate the local currency) are counterproductive and damaging to the global well-being.

    Actually they don’t. If you increase savings and this savings goes to either consumption or investment, this is a good thing. If the investment creates long term productivity, this is a very good thing.

    The economy should save in the good times and spend in the bad times. However people’s invididual self-interest runs against this, and people tend to spend in the good and save in the bad, which increases the volatility of the business cycle.

    Consumption is not demand.

  • Posted by Dr. Fleischer

    Yes, the economies are down various percentages. But when will they stabilize and stop going down? May be after 15%. This looks like 1929 all over again. Hungry third world people will not be passive as they starve.

  • Posted by don

    don: “However, right now we have a global deficiency in demand, and policies to artificially [encourage] domestic saving (currency interventions to deflate the local currency) are counterproductive and damaging to the global well-being.
    Twofish: “Actually they don’t. If you increase savings and this savings goes to either consumption or investment, this is a good thing. If the investment creates long term productivity, this is a very good thing.”
    Yes, actually they do. That is why Krugman (and the bulk of the profession) favor government spending over tax breaks to spur demand – because part of the tax break goes to increase saving. A policy to encourage saving now is most definitely detrimental to the global economy.
    It is a sign of the sad times the profession is in that one can quote Nobel laureates taking a position opposite to that of Krugman.
    And I’m sure you could find some that would argue that Japan’s export-led growth model was not a template for other Asian economies, but they would be equally mistaken.

  • Posted by Twofish

    don: Yes, actually they do. That is why Krugman (and the bulk of the profession) favor government spending over tax breaks to spur demand – because part of the tax break goes to increase saving. A policy to encourage saving now is most definitely detrimental to the global economy.

    I very strongly disagree. If you increase savings and those savings go into gold bars or treasuries, this is bad. If you increase savings and these savings go into starting new businesses and creating jobs, this is good.

    What matters is not the amount of savings, but what happens to those savings. If people start saving more money, and those savings go immediately to create new businesses and education, this is good. The problem with broken banks is that without good banks, the savings gets absorbed fixing old problems rather than going into new things.

    The reason you want to encourage savings is that policies that encourage savings take several years to establish, and you can’t just switch on and off marginal propensity to save.

    Don: And I’m sure you could find some that would argue that Japan’s export-led growth model was not a template for other Asian economies, but they would be equally mistaken.

    Facts are facts, and people who claim that East Asian nations copied Japan just don’t understand economic history.

    The orthodoxy in economic thinking in East Asia was import substitution untilthe early 1960’s, and Taiwan moved out of import substitution to export growth because it didn’t have any other choice in the matter. Taiwan didn’t have domestic capital to fund intensive import substitution, so it had to move to an export oriented economy for lack of any other alternatives.

    Most of Japanese growth happened in the late-19th century and early 20th, in which import substitution was the favored system.

    These are just facts.

    This also misses the point that the Japanese economy looks very little like the South Korean economy, the mainland Chinese economy or the economies of Hong Kong or Taiwan.

  • Posted by Judy Yeo

    Brad

    heard the latest about the korean economy? wpould have thought the slight easinag of the yen situation would have solved the repayment pressure (considering many korean firms actually financed their loans in yen last year). Rumours shaking the markets revolve around the possibility of a currency crisis engulfing the koreans, which brings to mind the question, could and would the japnaese and chinese come to the rescue in meaningful time. Yves’s highlighting of eastern europe’s pre carious state was certainly alarming, one wonders if the eurozone might not be dragged in further by the currency crisis that seems to be enveloping the region. Looks like the credit crisis has not just developed into a global financial crisis but rather into a financial chimera.

  • Posted by Judy Yeo

    apologies, by region was refering to the eastern european region

  • Posted by RebelEconomist

    Twofish,

    You say “Most of Japanese growth happened in the late-19th century and early 20th, in which import substitution was the favored system. These are just facts.”

    I am sceptical, but this is potentially interesting. Perhaps you could point us to said facts.

    The debate about stimulus between Krugman and Fama etc was adversarial and unproductive, and I would be interested in having a civilised discussion here about it. I thought Krugman did a poor job of answering Fama’s point about where the extra output is supposed to come from, but one has to respect the empirical evidence that stimulus does seem to increase output. The trouble is that it seems to be difficult to have a scientific debate about this issue because any question is taken as a partisan position. I thought that Clive Crook in the FT was spot on about the present dysfunctionality of academic economics.

  • Posted by df

    sorry brad my post got lost again coz of the stupid question …
    Hi rebel.
    I personnaly see nothing surprising in the present crisis.
    Long live India Brasil and France.
    Socialism is up, free market capitalism is out.
    Long live plannification, sustainable growth, energy economics. Death to hedonics.
    Let us have huge lay offs in the economics department globally.

    Finally the great upheaval is coming. The foolishness of past growth is revealed.

  • Posted by don

    Twofish, do you argue that the yen was not deliberately undervalued in much of the postwar period? That is the real question. Currency manipulation both encourages exports and discourages imports.
    The debate over the issue of whether saving should be encouraged in the present economic environment is not a real one and shows a very frustrating lack of economic understanding, more so when given credence by Nobel laureates in economics. Krugman is exactly right on this point. Fama, who recently espoused the idea of fiscal ‘crowding out’ (the counterpart of Twofish’s view that it is a good idea to encourage saving in the current environment) should be deeply embarassed. Fama stepped out of his areas of expertise and made a very basic blunder. He has made significant contributions to finance, and he deserves great respect when he talks about the correct way to structure bank bailouts. But the arguments he presented showed that he was completely unaware of a substantial body of knowledge in the area of macroeconomics. He simply repeated an old argument (called the “Treasury view”) that has been thoroughly discredited.

  • Posted by RebelEconomist

    don,

    So, discredit the treasury view then. Ad hominem arguments are not convincing.

  • Posted by don

    As simply as I can, actual saving equals actual investment, but that is no guarantee that desired investment will equal desired saving. If actual saving grows and forces actual investment to exceed desired investment (people don’t buy, so inventory is left on shelves), then business cuts back on output, forcing income (and actual saving) to decline. This is the so-called paradox of thrift.

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