A brief description of the economic model that collapsed with the crisis would include: a US economy based on over-consumption; a Chinese and East Asian economy based on exports catering to that consumption; a huge build-up of debt in the US to enable that consumption; cheap imports by the West that allowed prices to remain low, thus helping consumption; high asset prices that increase the value of collateral for borrowing, enabling more consumption; the relocation of production to low-cost centres, to make goods cheaper and thus increase consumption; financial innovation that leads to new financial products that increase leverage, which fuelled large increases in asset prices; and easy monetary policy that helped rising asset prices.
This system resulted in a rising share of profits for companies, as they were able to produce at the lowest cost centres and sell at the highest. It helped to keep wages down in the West, as production and even services could be shifted abroad.
The resulting inequality was compensated by high levels of personal indebtedness. As Richard Wolff, professor of economics at the University of Massachusetts, has said: “In effect, US capitalism…substituted rising loans for rising wages to workers.”
On the other hand, the globalization of production and services, and the internationalization of finance led to a huge boom in countries such as China and India.
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Now that the world economy has weathered the worst phase of the crisis, attention has shifted to the reform of the global economic system. At every meeting of global leaders, such as the Group of Twenty, there’s much talk of reform.
These include an increasing share in global decision making by countries such as India and China, a reining in of over-the-counter derivatives, more regulation of the financial system, more coordination among global regulators and a closer alignment of incentives to financial players with economic goals.
And finally, there are calls for a rebalancing of the global economy, with exporters such as China and Germany being urged to consume more, while the US is being asked to consume less.
But here’s the rub. If the US savings rate rises, as it has started doing and with deleveraging by the banks, consumption growth in the US will no longer be strong. But if consumption does not grow in the US, if debt and leverage do not pile up, if finance is hobbled, then the entire economic model that has been in place for the last 30 years is in danger of collapsing. And the American way of life, which George H.W. Bush once said is not negotiable, is in danger of disappearing.
So what is the way out? The markets believe that it will soon be back to business as usual. The existing system has plenty of supporters. All that is necessary, they argue, is to tweak it a bit, bring in more regulation, put a cap on bank bonuses and patch it up.
New bubbles will be found, till the next crash comes along. In fact, this could well be the solution preferred by the remaining banks, which will emerge stronger out of this crisis, as their competitors have disappeared. Goldman Sachs, for example, should be a big beneficiary.
A more sober solution is to have lower growth. Global imbalances will get resolved by themselves with lower US consumption reducing its trade deficit and lower exports reducing China’s surplus. But will the US be able to tolerate the high levels of unemployment this will involve? Won’t it lead to protectionist pressures?
Another way out would be a programme that would aim at full employment within the US and a redistribution of incomes to the poor. There are several objections to such a programme. One, the US fiscal deficit is already very high. Two, it would not work in the current environment of globalization. And most importantly, it’s pie in the sky and doesn’t have any chance of being politically acceptable.
So, how can the US maintain its living standards without increasing debt? By exports, of course. Hence the call for the trade surplus nations to consume more. The consensus seems to be, however, that it’ll take quite some time before the Chinese are in a position to substitute exports with domestic consumption.
They are also unlikely to allow the yuan to appreciate in a new Plaza Accord, knowing fully well that the Japanese economy has never recovered from the effect of letting the yen appreciate in that accord.
Michael Pettis, professor of finance at Peking University, has pointed out that China’s huge investment is based on its very low cost of capital, the result of keeping bank deposit rates very low, which results in very high savings as depositors struggle to build their nest eggs in the absence of a social security safety net.
But perhaps one thing that is not being taken into account is the low level of consumer debt in most emerging markets and even in some countries in Europe. It’s quite possible that financialization could shift from the Anglo-Saxon world to these countries, spurring consumption and growth there.
All the more reason then to expect funds to continue to flow into these markets. Especially to India, which has a sound banking system and an economy already based on domestic consumption.
Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at email@example.com