My goal here is to enumerate those issues that will determine the probable evolution of the global economy in the near future. The global economy is dominated by the economies of the US, Europe, and China, which together constitute 65% of global GDP. As such, these are the areas I’m focusing on to get a big-picture view of the global economy.
One might argue that the various struggles in the Middle East have important implications for the price of oil. This is true. However, this has generally been true for several decades, and I don’t expect the problem(s) to be resolved in the near future, which is the period I’m interested in.
One might also argue that other nations such as Brazil and India also make significant contributions to the global economy. This, too, is true. However, there’s not much going on in these countries at the moment that can be expected to have a significant impact on directions of the global economy in the near future, with the exception of their continued development, which I capture in the last issue.
So, what will are the big issues in the global economy for the near future?
A. The US
First, the US has been stagnant since the 2008 financial crisis, and the near future of the global economy will depend on when/how the US will overcome its current stagnation. The relevant issues here are: (i) why is the country continue to stagnate? and (ii) what can we expect from recent efforts to stimulate the economy?
1. The Financial and Real Estate Industries Still Contain Significant Amounts of Toxic Assets.
Starting in the early 2000s, various financing schemes for real estate fed a massive accumulation of toxic assets in the financial and real estate industries. Such practices led to over-inflated prices in real estate (and consumer durables), all of which collapsed with the bursting of the bubble.
Figure 1, taken from Casey Research, illustrates how assets previously classified as high quality (ratings of A+ and A), were suddenly revealed as being low quality (ratings of B through F) just prior to the financial collapse.
In order to lessen the pain experienced by consumers (home owners) facing mortgages and debt they can no longer afford, the government has continued to introduce regulations (e.g., preventing the banks from foreclosing) and stimulus money (e.g., buying up toxic mortgages, QE1, QE2). Such government intervention, though, has prevented the financial and real estate industries from cleaning out their toxic assets. As long as banks continues to hold so much bad debt, the real estate industry (and other durable asset industries) will not be able to recover. In other words, as long as the government continues to intervene in the financial markets by deterring the cleansing of toxic assets from the system, real estate and other hard asset prices will continue to experience deflation.
As an aside, many of the banks’ toxic assets (i.e., mortgages worth only pennies on the dollar, since most will default) have been bought by the Fed via stimulus programs. These transactions involved the Fed paying the banks closer to the face value of the toxic assets, as opposed to the fair market value. As a result, the banks were able to offload much of the toxic assets onto the Fed at hugely inflated prices, effectively bailing out the banks while leaving the Fed (taxpayers) with massive amounts of overvalued assets (mortgages).
2. Stimulus Money Is Not Being Lent by Banks
Despite the massive amounts of stimulus spending by the Fed over the past few years (QE1 and QE2), we haven’t seen much inflation in the US. This is due to the humongous amounts of bank reserves being kept on deposit at the Fed. The Fed currently pays banks 0.25% interest on excess reserves they keep on deposit at the Fed. In the current market environment (excessively low borrowing rates of interest), the banks are better off (i.e., make more money) keeping their cash on deposit at the Fed than they would be by lending the money out to borrowers. As a result, a huge portion of the money created by the Fed under the stimulus programs has not actually made it into circulation, but rather, it is sitting on deposit at the Fed (see Figure 2 taken from Liberty Street Economics). I call this the “wall of money” on deposit at the Fed.
When interest rates start to rise and hit a certain minimum threshold, this “wall of money” will start to be released into the economy, causing massive inflation -- unless something radically changes in the current market environment to counteract the excess supply of money.
3. US Government Debt and Unfunded Liabilities Will Lead to the Demise of the Dollar
We most often hear about the alarming $15.96 trillion national debt (more than 100% of GDP), and the 2012 budget deficit of $1.1 trillion (6.97% of GDP). As dangerous as those numbers are, they do not begin to tell the story of the federal government's true liabilities.
The actual liabilities of the federal government—including Social Security, Medicare, and federal employees' future retirement benefits—already exceed $86.8 trillion, or 550% of GDP. For the year ending Dec. 31, 2011, the annual accrued expense of Medicare and Social Security was $7 trillion.
Since taxes cannot begin to cover such high government debt, the only recourse is monetization (printing money), which means impending inflation and a weaker dollar.
The weakening of the dollar will continue to erode its status as the world’s reserve currency, eventually leading to its demise. Foreign nations have been increasingly discarding the use of the dollar to transact and instead using local currencies. From Tyler Durden, “After Creating Dollar Exclusion Zones In Asia And South America, China Set To Corner Africa Next “:
As a reminder: here is a smattering of our headlines on the topic from the last year: "World's Second (China) And Third Largest (Japan) Economies To Bypass Dollar, Engage In Direct Currency Trade", "China, Russia Drop Dollar In Bilateral Trade", "China And Iran To Bypass Dollar, Plan Oil Barter System", "India and Japan sign new $15bn currency swap agreement", "Iran, Russia Replace Dollar With Rial, Ruble in Trade, Fars Says", "India Joins Asian Dollar Exclusion Zone, Will Transact With Iran In Rupees", 'The USD Trap Is Closing: Dollar Exclusion Zone Crosses The Pacific As Brazil Signs China Currency Swap", and finally, "Chile Is Latest Country To Launch Renminbi Swaps And Settlement", we now get the inevitable: "Central bank pledges financial push in Africa."
To summarize: first Asia, next Latin America, and now Africa.
4. Economic Uncertainty Is Inhibiting New Investment
As long as the government continues to propose/introduce massive new regulations (e.g., financial industry overhaul, carbon tax, Obamacare, industry bailouts, changing tax laws, etc.), investors will be hard-pressed to determine which investment projects will be worthwhile. Additionally, weak economic environments in Europe and China are also contributing to the uncertainty. As such, many investors will delay investing in new projects and wait on the sidelines, until the various aspects of uncertainty have been resolved. In fact in “US Investment Falls Off a Cliff,” by Sudeep Reddy and Scott Thurm, the authors state precisely this:
U.S. companies are scaling back investment plans at the fastest pace since the recession, signaling more trouble for the economic recovery.
Half of the nation's 40 biggest publicly traded corporate spenders have announced plans to curtail capital expenditures this year or next, according to a review by The Wall Street Journal of securities filings and conference calls…
At the same time, exports are slowing or falling to such critical markets as China and the euro zone as the global economy downshifts, creating another drag on firms' expansion plans.
Corporate executives say they are slowing or delaying big projects to protect profits amid easing demand and rising uncertainty.
5. The New Normal Entails Lower Future Growth
“The New Normal” is a term coined by Mohamed El-Erian, CEO and co-chief investment officer of Pimco,
which predicts a post-financial-crisis world of lower investment returns, slower economic growth and higher odds of another out-of-the-blue financial shock. In short, a world in which the range of financial outcomes — and risk — is much wider than normal.
A significant portion of the high rates of growth in the US economy in the years preceding the 2008 financial collapse were fueled by mortgage equity withdrawals (MEWs). Quickly appreciating real estate prices and loose financial oversight enabled consumers to withdraw enormous amounts of equity from their ever-more-valuable homes, thereby enabling massive amounts of consumer consumption, which led to high GDP growth rates.
Figure 3, taken from Bill McBride’s blog, shows that without MEWs feeding consumer consumption, GDP growth rates would have been only about 1% per year during the early and mid 2000s, rather than the 4% the economy actually experienced. Since the bubble has collapsed and many real estate financing schemes have been revealed as fraudulent, real estate prices have collapsed and will continue to wallow until the debt has been cleansed from the system. In the meantime, the MEWs that fueled the high GDP growth during the recent past will not be available to fuel growth in the (near) future. This means that the US economy will experience only low GDP growth rates into the near future, unless something else comes along to provide similar types of fodder that MEWs did.
The second big area of concern in the global economy is Europe. Europe is currently embroiled in an existential crisis. The main issue driving the crisis is whether or not the Eurozone is sustainable in its current form.
6. The Euro Is Unsustainable in Its Current Form
Most of the Western European counties have joined together to create a free trade zone among member European Union (EU) countries. Europe consists of a large group of heterogeneous countries, most of which have populations with strong senses of national cultures (e.g., productivity and work ethics), heritages, and pride. Despite these national differences, in 1999, a subset containing 17 EU countries agreed to combine their national currencies into a single currency system, the Eurozone.
According to George S. Tavlas, “Benefits and Costs of Entering the Eurozone,” the three main benefits to Eurozone countries associated with using a common currency (the euro) are (i) the elimination of exchange rate uncertainty, (ii) the elimination of transaction costs of converting currencies, and (iii) the gain in credibility to inflation-prone countries. More specifically,
A major benefit of participating in the EMU, especially among countries such as Greece, Italy, Portugal, and Spain that have had recent histories of relatively high inflation rates, has been the credibility gain derived from eliminating the inflation-bias problem of discretionary monetary policy ... With low and stable inflation and inflation expectations, nominal interest rate differentials between these countries and countries with histories of relatively low inflation rates, such as Germany, have been essentially eliminated (Figure 1)... With lower nominal interest rates, the cost of servicing public-sector debt is reduced …
Sure enough, the creation of the common currency has led to increases in trade among Eurozone countries, as well as with other non-Eurozone trading partners. However, new credibility gained by countries with poor inflation histories, namely Greece, Italy, Portugal, and Spain (PIGS), enabled them to run increasingly large trade deficits. Had PIGS each had their own currency, then small trade deficits would have caused their currencies to depreciate against those of their trading partners, thereby inhibiting further increases in their trade deficits. Yet, without such exchange rate discipline, PIGS were free to increase their deficits to unsustainably large levels. For example, in Figures 4 and 5 I present the trade balances for Greece and Spain. Notice how imports (“arrivals” from other EU countries and “imports” from non-EU countries) were initially relatively stable, but then they started to increase relatively rapidly until the financial crisis struck in 2008.
Artificially low borrowing rates for these countries have led them to run up unsustainably large debts in general, leading to the current crisis in Europe, which they’re trying to resolve as I write, mostly by bailing out the countries that are in trouble.
Germany in particular is pushing strongly for a resolution that will leave the Eurozone intact. Germany has benefitted tremendously from the creation of the Eurozone through increases in exports to other (Eurozone) countries, and it doesn’t want to see its exports recipients be impaired.
The pols trying to negotiate a resolution to the Eurozone crisis are pushing for the troubled countries to impose harsh austerity measures, which might address some of the underlying problems. However, the troubled countries have been strongly resisting the austerity measures, and the pols have agreed to temporary bailouts in the meantime.
The fundamental problem here is the starkly different cultural attitudes in the different Eurozone countries regarding productivity and work ethics. In particular, the people of Greece want the high standards of living that come with high worker productivity, but they also want short work weeks, plenty of vacation time, and early retirement. They simply cannot have both. Unless proponents of a single currency are able to fundamentally change the attitudes and capabilities of the workers in the troubled countries, then having a single currency for productive and unproductive countries alike will continue to cause debt problems in the unproductive countries.
The third area of concern in the global economy is China. The ongoing development of China, together with its current role in the global economy, has given the country enormous clout. The two biggest concerns with regard to China have been (i) Where is the economy going? and (ii) How do we (the US in particular, but other WTO countries as well) get China to play by the rules? When discussing these issues, many (most?) analysts tend to consider how the country should be expected to behave under the assumption that the country is a democracy and a market economy. The fact that China is not either of these makes most of these analyses moot.
7. China Is Not a Democracy and Does Not Have a Market Economy
China is an oligarchy, run by the Communist Party, whose members are self-serving and will continue to do what’s in their own best interest, regardless of how much they antagonize other countries in the world. From “Tackling the Many Dangers of China's State Capitalism” by John Bussey,
The Communist Party of China has two unwavering objectives: Make China rich and powerful and guarantee the Party's political monopoly … At the center of this are behemoth state-owned enterprises that dominate all key sectors and have been instrumental to the country's current success.
What’s in the best interest of the ruling class is to keep the people from uprising, which means providing jobs and affordable food prices so the people can provide for themselves. Jobs are provided by funneling money into projects that will create jobs. That is, money is allocated to projects based on political concerns, not profitability concerns, which means China is decidedly not a market economy. Furthermore, since funds tend to be allocated based on political need, most projects are inherently unprofitable. Were the state to withdraw its support from state-funded projects, the entire economy would collapse.
There is generally a complete lack of transparency in the financial workings of companies, and there is no infrastructure to ensure contracts are met. Corruption, piracy, embezzlement, etc. are all endemic to the way businesses are run. In “Ethical Issues in the Evolution of Corporate Governance in China,” Dr. Choong Y. Lee and. Ms. Ha Sook Kim note
Although all facets of modern market instruments have now been adopted [in China] from free market economies, they have to operate under an environment where the social and economic preconditions for their effective functioning are at times lacking or underdeveloped. This may be an inevitable consequence of China's gradual approach to economic reform, but the asymmetrical progress has also paved the ground for the emergence of various issues in business ethics. Corruption, stock market manipulation, tax cheating, fraudulent dealings, all manners of plundering of state assets and the lack of shareholders' rights are some of the more conspicuous manifestations.
The Chinese people generally hoard money to protect against the future (there are no government support systems), so consumer spending constitutes a smaller portion of the economy than that of most other nations. As such, the Chinese economy is hugely dependent on exports to generate growth. The party will do whatever it needs to do to support exports, such as keeping its currency devalued, dumping onto world markets, engaging in industrial piracy and espionage, etc.
Finally, there is a final issue to consider that does not fit into any of the US, Europe, or China categories, but that will have a large impact on future developments in the global economy. Namely, a huge portion of the world’s population is for the first time in history starting to generate disposable income, which will have an enormous impact on the prices of global resources.
8. The Developing World Is Consuming an Increasing Portion of Global Resources.
Trends toward increasing globalization over the past thirty years or so have helped the developing world (e.g., BRIC – Brazil, Russia, India, China) begin to grow to such an extent that their economies have been increasingly impacting the global economy.
For example, Figure 6, taken from IEA 2001 Key World Energy Statistics shows how Non-OECD countries collectively have been consuming an ever-larger portion the world’s total energy consumption since the early 1970s. In particular, China has increased is share of global energy use from 7.9% in 1973 to 17.3% in 2009.
As a significantly larger portion of the global population enters the middle class, their demand for commodities will continue to rise. That is, there will be inflation in food and energy prices into the future as developing nations consume a larger portion of the world’s resources.
Food and energy supplies are relatively inelastic (fixed) in the short run, which means prices can rise and fall relatively quickly with changes in global demand. In particular, as the global economies started overheating in 2007 and 2008, food and energy prices rose rapidly as demand for the limited available stock quickly bid up prices. Then, when global demand dropped during the financial crises and its immediate aftermath, food and energy prices dropped as well. As global demand has started rising recently, so have food and energy prices.
This establishes what I believe to be the basic drivers of the global economy. Future postings will discuss implications of these issues and update the drivers as they change.