This article is the first of three pieces in our special report on the recovery. Click to read the second. Click to read the third.
Of the major world economies and regions, only the United States has largely fixed its financial system following the crisis. It has stabilised overall debt levels, private as well as government. Household debt is also well down from its peak, and monthly debt service payments are at the lowest level on record. Budget deficits soared in 2009, as the government injected capital into the economy to stop its collapse into depression, but have since been more than halved to below 6 per cent of output, and are falling still. Overall, the US government’s debt burden is stabilising at slightly less than its entire annual economic output. This is still too high, but better than in Spain, Portugal and Italy, where debt levels relative to output are still rising, as they are in Japan and China.
A course of debt-crisis medicine is required, and this consists of what might be called “The Three Ds”: devaluation, deflation and default. The first of these, devaluation of the value of a currency, makes exported goods cheaper and so tends to encourage exports, sustaining output. The two together mean businesses and people are saving more. The second, deflation, reduces consumer spending and holds back the inflation that can sometimes follow a currency devaluation. Third, a default during which financial institutions or members of the public fail to pay back debts shifts some of the pain to lenders who made foolish pre-crisis loans.
The US had all three of these. Quantitative easing, the process by which a central bank injects money into the economy, devalued the dollar. Tough fiscal tightening curbed the budget deficit. Finally, a lot of household debt was written off as households defaulted. The contrast with the Club Med countries could not be greater. Eurozone nations cannot devalue their currency individually because they share a currency. The entire burden of adjustment in Spain, Portugal and Italy has thus fallen on deflation, as governments have aggressively cut their spending. The result has been very bad. Massive unemployment may have enabled the Club Med countries to eliminate their deficits, but each country’s level of debt compared to its economic output is now worse than during the crisis in 2007 to 2009.
Low interest rates in the five years leading up to 2007 fuelled the debt orgies of the US, Britain, Ireland and Club Med. These low rates were made possible by an export-led, high-savings strategy, which has been pursued by several nations since the 1950s, starting with Germany’s Wirtschaftswunder—economic miracle—followed by Japan in the 1960s, Korea in the 1970s, then the Asian Tigers, and finally China. Exporters need buyers, and the thing this strategy needed most was the US as the “market of first resort.” As a result, the US and other importing countries needed to run up their debt levels. The result was a global imbalance between increasing debt burdens in borrower nations and a reliance on exports in surplus countries. This imbalance was at the root of the financial crisis.
What have the surplus countries done to adjust? Essentially nothing. In 2007, before the financial crisis, Germany’s savings exceeded spending by 8 per cent of GDP. Last year’s numbers were virtually identical. Its “structural” budget deficit—the part that reflects government decisions—was 3 per cent in 2010, when the euro-crisis first struck, and had been cut to almost zero last year. Alongside the Club Med countries, the German government has also been cutting; but this has made cost adjustment even harder for Club Med countries, which cannot lower their prices enough to compete with Germany. In this way, the eurozone has become a black hole of deflation. Its demand is $400bn less than its output, and this surplus cash pours into world financial markets.
In the other two big saver nations, Japan and China, the picture is very different. In Japan, the private sector saves an amount equivalent to 30 per cent of GDP. In 2007, the number was the same. Formerly, much of that saving was offset by a high level of exports, but Japan’s share of export markets has halved in the past 20 years and the current account is now in deficit. So instead of exports, the offset to the excessive private saving is now mostly the budget deficit—nearly 10 per cent of GDP, in a country where government debt is already equal to 140 per cent of GDP. Japan is now doing to itself what it previously did to the US—driving debt up to, and probably well beyond, sustainable limits. Nearly all of the saving is in business, not households. Japanese corporations have a cash flow $400bn greater than their investment needs. Keeping that amount of cash in yen would be dangerous, so that $400bn of cash will seek a home in world markets.
In China, the national savings rate is a mountainous 50 per cent of GDP—again, the same as it was in 2007. When exports collapsed in 2008-09 China’s government responded with top-down, “lend and spend” directives that pushed its investment rate up to 48 per cent of GDP. This brought huge waste, serious wage inflation and a rapid build-up of debt, nominally private but which will almost certainly lead to default and government bailout. Just like Japan, China has been doing to itself what it previously did to the debtor economies. Now that the dollar is weak and debtor economies need to bring down their debt ratios, economies that rely on export-led growth are experiencing difficulties. Nonetheless, China continues to be in significant surplus—its slowdown has affected imports too—and its reserves increased by $500bn over the past year, all of that money also seeking a home and finding one in the financial markets.
With the likes of India and Brazil now cutting back, most of this global flush of cash has poured into the Anglo-Saxon financial markets. Britain has seen the pound driven up high while interest rates have stayed remarkably low. As for the US, it is surprising that the dollar has not appreciated more. This flow of funds is extremely significant. It is a major factor in holding down the cost of US mortgages and encouraging the housing revival. It is driving up the price of housing, real estate and the stock market, contributing a wealth effect boost to the US economy. These price rises are unlikely to slacken much over the next year, unless geopolitical issues—already alarming—worsen further.
From a growth perspective, US fiscal policy is now neutral, and monetary policy is still aiming to stimulate the economy, if less so than before. The sharp decline in government spending has come to a halt in the past couple of quarters, and is unlikely to resume. Taxes probably won’t be raised. Even when quantitative easing is finished this autumn, zero interest rates will represent a significant stimulus in an economy with inflation in the 1.5 per cent region; this should remain the situation until next spring at least. When rates do finally rise, they could remain below inflation for another year, possibly longer.
An advantage enjoyed by the US is in its pent up demand, not least for cars and housing, as well as the positive impulse from shale energy. The undervalued dollar has also led to growth in business spending. Because of the favourable exchange rate the pace of business off-shoring, where businesses move some operations to countries where it is cheaper to conduct them, is slowing and the trend may even be going into reverse. Business spending has been growing more than twice as fast as GDP. That should continue as the economy gathers momentum.
The big question in the US is over consumer spending—most analysts suggest it will be strong. People are saving at a rate substantially higher than the long-term trend, given current levels of wealth, so consumer spending could soon be buoyant. Seven years on from the financial crisis, car sales remain below their pre-crisis trend, implying that a lot of people are due a replacement. Job growth is also rapid.
What does this all amount to? Decent growth in the US, at about 3 per cent for the next couple of years. This could be accompanied by continued subdued wage inflation, which so far has kept inflation down—and suggests inflation is unlikely to rear its head in the next year or so. Even beyond that, the likely appreciation of the dollar could reduce the chances of inflation taking hold. In the absence of any major global political troubles, and there are plenty of potential candidates, the American economy could perform well over the next year.
Of the major world economies and regions, only the United States has largely fixed its financial system following the crisis. It has stabilised overall debt levels, private as well as government. Household debt is also well down from its peak, and monthly debt service payments are at the lowest level on record. Budget deficits soared in 2009, as the government injected capital into the economy to stop its collapse into depression, but have since been more than halved to below 6 per cent of output, and are falling still. Overall, the US government’s debt burden is stabilising at slightly less than its entire annual economic output. This is still too high, but better than in Spain, Portugal and Italy, where debt levels relative to output are still rising, as they are in Japan and China.
A course of debt-crisis medicine is required, and this consists of what might be called “The Three Ds”: devaluation, deflation and default. The first of these, devaluation of the value of a currency, makes exported goods cheaper and so tends to encourage exports, sustaining output. The two together mean businesses and people are saving more. The second, deflation, reduces consumer spending and holds back the inflation that can sometimes follow a currency devaluation. Third, a default during which financial institutions or members of the public fail to pay back debts shifts some of the pain to lenders who made foolish pre-crisis loans.
The US had all three of these. Quantitative easing, the process by which a central bank injects money into the economy, devalued the dollar. Tough fiscal tightening curbed the budget deficit. Finally, a lot of household debt was written off as households defaulted. The contrast with the Club Med countries could not be greater. Eurozone nations cannot devalue their currency individually because they share a currency. The entire burden of adjustment in Spain, Portugal and Italy has thus fallen on deflation, as governments have aggressively cut their spending. The result has been very bad. Massive unemployment may have enabled the Club Med countries to eliminate their deficits, but each country’s level of debt compared to its economic output is now worse than during the crisis in 2007 to 2009.
Low interest rates in the five years leading up to 2007 fuelled the debt orgies of the US, Britain, Ireland and Club Med. These low rates were made possible by an export-led, high-savings strategy, which has been pursued by several nations since the 1950s, starting with Germany’s Wirtschaftswunder—economic miracle—followed by Japan in the 1960s, Korea in the 1970s, then the Asian Tigers, and finally China. Exporters need buyers, and the thing this strategy needed most was the US as the “market of first resort.” As a result, the US and other importing countries needed to run up their debt levels. The result was a global imbalance between increasing debt burdens in borrower nations and a reliance on exports in surplus countries. This imbalance was at the root of the financial crisis.
What have the surplus countries done to adjust? Essentially nothing. In 2007, before the financial crisis, Germany’s savings exceeded spending by 8 per cent of GDP. Last year’s numbers were virtually identical. Its “structural” budget deficit—the part that reflects government decisions—was 3 per cent in 2010, when the euro-crisis first struck, and had been cut to almost zero last year. Alongside the Club Med countries, the German government has also been cutting; but this has made cost adjustment even harder for Club Med countries, which cannot lower their prices enough to compete with Germany. In this way, the eurozone has become a black hole of deflation. Its demand is $400bn less than its output, and this surplus cash pours into world financial markets.
In the other two big saver nations, Japan and China, the picture is very different. In Japan, the private sector saves an amount equivalent to 30 per cent of GDP. In 2007, the number was the same. Formerly, much of that saving was offset by a high level of exports, but Japan’s share of export markets has halved in the past 20 years and the current account is now in deficit. So instead of exports, the offset to the excessive private saving is now mostly the budget deficit—nearly 10 per cent of GDP, in a country where government debt is already equal to 140 per cent of GDP. Japan is now doing to itself what it previously did to the US—driving debt up to, and probably well beyond, sustainable limits. Nearly all of the saving is in business, not households. Japanese corporations have a cash flow $400bn greater than their investment needs. Keeping that amount of cash in yen would be dangerous, so that $400bn of cash will seek a home in world markets.
In China, the national savings rate is a mountainous 50 per cent of GDP—again, the same as it was in 2007. When exports collapsed in 2008-09 China’s government responded with top-down, “lend and spend” directives that pushed its investment rate up to 48 per cent of GDP. This brought huge waste, serious wage inflation and a rapid build-up of debt, nominally private but which will almost certainly lead to default and government bailout. Just like Japan, China has been doing to itself what it previously did to the debtor economies. Now that the dollar is weak and debtor economies need to bring down their debt ratios, economies that rely on export-led growth are experiencing difficulties. Nonetheless, China continues to be in significant surplus—its slowdown has affected imports too—and its reserves increased by $500bn over the past year, all of that money also seeking a home and finding one in the financial markets.
With the likes of India and Brazil now cutting back, most of this global flush of cash has poured into the Anglo-Saxon financial markets. Britain has seen the pound driven up high while interest rates have stayed remarkably low. As for the US, it is surprising that the dollar has not appreciated more. This flow of funds is extremely significant. It is a major factor in holding down the cost of US mortgages and encouraging the housing revival. It is driving up the price of housing, real estate and the stock market, contributing a wealth effect boost to the US economy. These price rises are unlikely to slacken much over the next year, unless geopolitical issues—already alarming—worsen further.
From a growth perspective, US fiscal policy is now neutral, and monetary policy is still aiming to stimulate the economy, if less so than before. The sharp decline in government spending has come to a halt in the past couple of quarters, and is unlikely to resume. Taxes probably won’t be raised. Even when quantitative easing is finished this autumn, zero interest rates will represent a significant stimulus in an economy with inflation in the 1.5 per cent region; this should remain the situation until next spring at least. When rates do finally rise, they could remain below inflation for another year, possibly longer.
An advantage enjoyed by the US is in its pent up demand, not least for cars and housing, as well as the positive impulse from shale energy. The undervalued dollar has also led to growth in business spending. Because of the favourable exchange rate the pace of business off-shoring, where businesses move some operations to countries where it is cheaper to conduct them, is slowing and the trend may even be going into reverse. Business spending has been growing more than twice as fast as GDP. That should continue as the economy gathers momentum.
The big question in the US is over consumer spending—most analysts suggest it will be strong. People are saving at a rate substantially higher than the long-term trend, given current levels of wealth, so consumer spending could soon be buoyant. Seven years on from the financial crisis, car sales remain below their pre-crisis trend, implying that a lot of people are due a replacement. Job growth is also rapid.
What does this all amount to? Decent growth in the US, at about 3 per cent for the next couple of years. This could be accompanied by continued subdued wage inflation, which so far has kept inflation down—and suggests inflation is unlikely to rear its head in the next year or so. Even beyond that, the likely appreciation of the dollar could reduce the chances of inflation taking hold. In the absence of any major global political troubles, and there are plenty of potential candidates, the American economy could perform well over the next year.
