Key Trends in Globalisation

Germany's 'continental economy' - comparisons to the US, India and China

Data released by the German statistical service shows how much Germany, until this year the world's largest exporter, and still the second largest, relies on its European market - particularly in a period of severe economic downturn such as 2009.

Approximately three quarters of German exports were to European countries. 63% of all exported German goods were delivered to the member states of the European Union.

Asia, the second most important market for German export goods in 2009, trailed far behind with 14% of German exports. The US accounted for 10%.. Africa and Oceania (including Australia) accounted for only 2% and 1% of German exports.

In terms of imports Germany was almost equally Europe dominated. 71% of Germany's imports came from Europe, with 18% from Asia and 9% from the US. Goods from Africa and Oceania represented just 2% and 0.4%, of Germany's imports.

Germany's economy, in short, is not really a balanced 'international' one - in particular in an economic downturn. It is, in export terms in particular, a European continental economy with secondary add ons in Asia and the US.

What implications flow from this?

World share markets have so far regained half their losses

As world stock markets have been rising since February 2009, and the dominant US markets since March 2009, the data below shows it is an appropriate moment to make a balance sheet of how far this recovery has gone, In summary it may be noted that approximately half of the falls since the lows in early 2009 have been regained.

According to the monthly data of the World Federation of Exchanges the international share markets of affiliated exchanges, which count for very close to the totality of world stock market capitalisation, peaked at a combined value of $63.0 trillion in October 2007. This then fell to $28.7 trillion in February 2009 - a drop of $34.4 trillion or 54.6%.

The capitalisation of the New York Stock Exchange (NYSE) declined from a peak of $16.6 trillion in June 2007 to a trough of $7.9 trillion in March 2009 - a fall of $8.7 trillion or 52.1%.

From the trough in February 2009 to the latest monthly figures for January 2010 the capitalisation of world exchanges had recovered to $46.8 trillion - $16.4 trillion, or 26.0%, below their peak levels.

The New York Stock Exchange had recovered to a market capitalisation of $12.2 trillion - $4.4 trillion, or 26.4%, below its peak.

In short both for world exchanges and for the NYSE by the end of January 2010 almost exactly half the losses since world share markets reached their peak have been regained.

It, of course, remains to be seen in the future whether the second half will be regained and over what period.

The world data is shown in the chart below.

China and India – economic growth and the struggle against inflation

India and China are engaged in separate but parallel struggles with inflation. Both have responded by monetary tightening. Such tightening affects inflation via its effect on demand and its interrelation with the supply side of the economy. This article, therefore, analyses macroeconomic determinants of the supply side of China's and India's economies and its effect on inflation and their relative growth rates. In particular it considers the relative efficiency of investment in China and India and the consequences of this for inflation and growth.

As this article is somewhat more statistical than most on this blog it may be useful to summarise its conclusions - readers can turn to the article for the supporting evidence.

1. Analysis of macro-economic parameters clearly confirms other forms of study that both the Chinese and Indian economies are up against or approaching inflationary capacity constraints. Therefore, for example, the analysis that China is facing an overall problem of 'overcapacity' is the reverse of the truth - China is facing an overall problem of constraints on capacity which has inflationary consequences.

2. As China is suffering from inflationary capacity constraints the argument made by some commentators that in 2009, and at present, China's policy makers should aim at increasing domestic demand only via increasing domestic consumption, and not also increasing domestic investment, is false - such a policy, by increasing demand but not tackling capacity constraints, would increase inflationary pressures. The Chinese authorities in 2009 were therefore right to have expanded both domestic investment and domestic consumption. This remains the correct policy.

3. India's domestic savings level combined with a policy of accepting a moderate, i.e. up to 3% of GDP, balance of payments deficit makes it credible for India to aim at a double digit, or close to double digit, economically sustainable growth rate. The projections for India's growth at the latest Indian Prime Minister's Economic Advisory Council, of 7.2% in the current fiscal year and over 8% in the next, appear even moderate compared to the macro-economic potential - indicating that either, or both, India has ample strategic margin to contain inflation or that growth rates will exceed these projections.

4. There is not a statistical basis for the claim that India is able to make more efficient  use of investment than China and therefore that India will be able to match China's growth rate with a lower level of investment. India's efficiency of the use of investment, from the point of view of economic growth, is almost exactly the same as China's and therefore, unless there is a change in this, their relative growth rates will continue to be determined by which country invests a higher proportion of GDP.

5. China, on the basis of the level of of investment achieved in 2009, should be able to sustain the approximately 12% GDP growth which is likely in the early part of 2010 without seriously destabilising  inflationary capacity constraints. However further acceleration, without an increase in the level of investment, would be likely to produce unsustainable capacity constraints and therefore the Chinese authorities are correct to have begun to rein in the rate of acceleration of the economy.

The more detailed analysis of these points follows.

Big business in the US and European Union

The Financial Times carries an article, by Richard Milne, on the situation of small and medium business in Europe during the international financial crisis. This contains some interesting information on economies of scale and productivity in Europe and the US.

In the US 45% of employment is by enterprises with more than 250 employees, compared to only 33% in the European Union (EU). The definition of a small and medium enterprise (SME) used was that it employed less than 250 people, a small enterprise was defined as employing 10-49 staff, and a micro-enterprise as one with under 10 employees.

The EU contained 20.4 million SMEs and only 43,000 large companies. Of the SMEs 92% were micro-enterprises.

Taking the ratio of SMEs to population the country with the smallest ratio of SMEs to population was Germany – Europe's most successful economy.

The average productivity of labour in European small and medium enterprises was significantly lower than in large enterprises. EU SMEs in 2005, the latest year for which data is available, accounted for 67% of jobs but only 58% of value added. Because of lack of economies of scale EU SMEs had a productivity that was only 86% of the EU average.

The conclusions which flow from this are evident.

Barclays Capital, John Maynard Keynes and Hyman Minsky

A report for Barclays Capital on recoveries in share prices after severe falls, such as in 1982 or 2009, is important for stock market investors. But it also throws a light on economic theory.

As John Authers notes in the Financial Times: 'Looking for the key factors driving such recoveries, Barclays found that economic growth and profits were not particularly important. Instead, the strongest link was with credit spreads. Provided credit continued to get cheaper (as shown by the extra spread for corporate debt compared to government debt), then relief rallies could continue. Once credit spreads widen, equities cannot make much headway.' Authers' video on this, which contains further statistical illustration, is well worth watching.

What is expressed in this data is not only changes in evaluation of risk but a rather good practical illustration of changes in liquidity preference. Keynes in The General Theory of Employment Interest and Money clearly explained that for investment to take place it is not sufficient for the rate of profit to exceed by a minimal fraction the rate of interest. There is an advantage in holding flexible assets, cash or near equivalents, compared to non-flexible ones. For investment to be take place it is therefore necessary that the rate of profit equal at least the rate of interest plus whatever rate of return is necessary to induce the investor to forego the advantage of liquidity. The rate of return sufficient to create an inducement to forego liquidity, that is to offset liquidity preference, changes according to circumstances. Hyman Minsky, of course, analysed some consequences of this when, as in a modern economy, investment is carried out on the basis of credit. Risk is a factor influencing the rate of return that must be offered to overcome liquidity preference.

While Keynes was analysing the development of effective demand in the productive economy, and shares are far more liquid than productive assets, nevertheless the same process is clearly working. The Barclays Capital data is therefore of interest not only practically from the point of view of stockmarket investing but from the viewpoint of illustrating and validating economic theory.

The Economic Times on the fight against inflation - lessons that apply to China as well as India

The Economic Times is India's leading financial newspaper. Today it carries an editorial on India's current fight against inflation. But lessons drawn in the editorial apply far more widely than only India.

Regarding India itself the Economic Times notes that the wholesale price index, used as the country's benchmark inflation rate, has risen to 8.6% in January. It however believes that this number is so far not as serious as it appears at first sight as it is based in short term pressures on food prices, worsened by the very poor 2009 monsoon, and upward price shifts that have appeared in some manufacturing sectors,  But it concludes: 'That said, the threat of core inflation accelerating in the months ahead as economic activity and demand pick up, remains.'

In the light of this latter consideration the editorial, regarding monetary policy, supports the tightening started by India's central bank raising reserve requirements in January. Regarding fiscal policy the editorial argues the Indian government must contain the budget deficit and 'reallocate expenditure away from consumption towards investment,'

This means that the Economic Times understands the general fight against inflation more accurately than do some other commentators. Containing inflation requires measures not only on the demand side (tightening monetary policy, preventing excessive budget deficits) but also on the supply side - increasing supply by removing capacity constraints. Removing supply side blockages requires investment - hence the correctness of the editorial's call for a shift of expenditure from consumption into investment,

When capacity constraints are appearing in an economy a policy only of increasing consumption, which by definition does not add to capacity/supply but only to demand, is inflationary. Investment, which adds to supply as it comes on stream, on the contrary strategically contains inflation by removing capacity constraints.

The country to which this point applies particularly clearly at present, in addition to India, is China. China has seen the emergence of clear inflationary capacity constraints. Some commentators have been calling for China simply to increase domestic demand by increasing domestic consumption and not also to increase domestic investment.Such a policy of increasing domestic consumption, without an increase in investment, under conditions of capacity constraints, would add to inflationary pressures.

The Economic Times editorial is correct on this point regarding India. But it also applies to China.

This issue is of great importance in looking at the present economic situation in both China and India and this blog will be coming back to it. Meanwhile the Economic Times editorial deserves consideration more widely than only in India.

The myth of the decline of the US consumer

A widespread myth about the international financial crisis is that what is taking place is a serious reduction of consumption in the US, with the knock on consequences that would flow from this for the world economy. The present article shows that this myth is factually untrue. No major downturn of US consumption has taken place. Therefore such a non-existent downturn in US consumption cannot be the driving force of either the US or international  ‘Great Recession’. 

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The claim that a key driving force of the present international 'Great Recession' is a major downturn of US consumption is a frequent one. We will take as an example of this argument Stephen Roach’s book The Next Asia - all page references therefore refer to this work. Roach, president of Morgan Stanley Asia, is chosen because he is a coherent economist who spells out this mistaken claim more lucidly than many far less serious economists who make it.

According to Stephen Roach what is taking placed is the 'capitulation' of the US consumer. Thus Roach refers to, ‘America’s postbubble compression of consumer demand.’ (p378).

This alleged reduction in US consumption is then cited as the driving force of the economic downturn. As Stephen Roach put it:‘The current recession is all about the coming capitulation of the American consumer.’(p20) Therefore: ‘The main event… is the likely capitulation of the overextended, savings-short, overly indebted American consumer.’(p42). Roach concludes that: ‘After a dozen years of excess, the overextended American consumer is finally tapped out… Hit by the triple whammy of collapsing property values, equity wealth destruction, and an ongoing unemployment shock.’(p325)

As a result of this situation a major reduction in the share of consumer spending in the US economy is foreseen. Stephen Roach concludes: ‘the US consumption share of real GDP, which hit a new record of 72.4% in the first quarter of 2009, needs, at a minimum, to return to its prebubble norm of 67% ... the die is cast for a protracted weakening of the world’s biggest spender.’(p32) The situation is therefore that: ‘the US consumer [is] most likely in the early stages of a multi-year contraction’ (p79) Indeed: ‘Despite the unprecedented contraction of consumption in late 2008, there is good reason to believe the capitulation of the US consumer has only just begun.’ (p385)

It is this alleged reduction of US consumption which, it is asserted, will cause the slowdown in the world economy: ‘The postbubble shakeout stands to be dominated by a protracted adjustment of the US consumer – providing powerful and lasting headwinds on the demand side of the global economy for years to come.' (p396)

The problem for this thesis is that it is factually incorrect. No such major reduction of US consumption has taken place. The share of consumption in US GDP has expanded and not contracted. And, as no significant reduction of US consumption has taken place, it therefore cannot explain any of the current trends in the world economy

To show the factual situation Figure 1 graphs the percentage change in the major components of US GDP between the 2nd quarter of 2008, the last before the US recession began, and the most recent available data - that for the 4th quarter of 2009. During this period US GDP contracted by -1.9%. However the reduction in US personal consumption was only -0.6%. Government expenditure, consumption and investment taken together, increased by 3.1%.

Compared to the relatively small fall in US personal consumption the really large declines were in US residential fixed investment, which dropped by -21.2%, and in US non-residential fixed investment, which declined by -20.3%, In other words, as regards the US domestic economy, what occurred was not a consumer decline but a large investment fall.

As regards the external relations of the US economy there were also declines in exports, down -7.7%, and a major drop in imports - by -12.3%.

Compared to these major shifts in investment and trade the decline in US consumption was extremely small and played almost no role in the economic contraction.

Figure 1

To show the real shifts in the US economy even more starkly, and illustrate further that the 'decline of US consumption' is a myth, Figure 2 shows the shifts in the major components of US GDP from the 2nd quarter of 2008 to the 4th quarter of 2009 in monetary terms - i.e. in current prices.

New US and China trade figures show error in Martin Wolf's analysis of global imbalances

The US and China have published new trade figures – the US for December 2009 and China for January 2010. These show another increase in the US trade deficit and a further reduction in China's trade surplus.

Both sets of figures are  important data in themselves regarding the state of the world economy. However they also again reveal the error of one of the most influential theories of the present international economic situation – that probably most prominently promoted by Martin Wolf in the Financial Times and at book length in his Fixing Global Finance. 

According to this theory the US balance of trade deficit is not principally caused by excessive consumption in the US but is forced on the US by excessive saving by Asian countries – notably China. Variants of the same thesis have been presented by Stephen Green of Standard Chartered, by David Cohen of Action Economics, by Brad Setser, by Michael Pettis of Peking University, and other authors.

The issue at stake in this is not primarily bilateral trade, which is affected by many elements, but the overall development of 'global imbalances' - i.e. the excess of China's domestic saving over domestic investment, reflected in its balance of payments surplus, and the shortfall of US domestic saving compared to its domestic investment which is represented by its balance of payments deficit.

If the theory is correct that the trade deficit is not primarily created by US excess consumption but is 'forced' on the US by the trade surplus of China then this has clear factual implications. A fall in China's trade surplus should lead to a shrinking of the US trade deficit, while a widening of the US trade deficit should be accompanied by an expansion of China's trade surplus. 

China and the fight against inflation in 2010

This author of this blog author has a new article up at China.org.cn. It analyses how China is placed to deal with the threat of inflation in 2010. In considering how likely China is to be able to deal with inflationary capacity restraints it contains an analysis of the efficiency of investment in China and India.