Key Trends in Globalisation

Fundamental driving forces of the financial crisis

It is superfluous to note on this blog that the world economy is passing through the most severe financial crisis since 1929.[1] Its results are also beginning to be well understood: the era of increasing deregulation has ended and instead increased, in the US very large scale, state intervention in the economy has begun.[2]

But what type of crisis is this - which greatly affects what its eventual outcome will be?

The most trivially superficial explanation, put forward in tabloid newspapers and demagogic political speeches, is that this is an extremely severe short term convulsion caused by the activities of ‘financial spivs’ and ‘short sellers’– modern embodiments of the ‘gnomes of Zurich’ denounced by British Prime Minister Harold Wilson in the 1960s, Slightly less superficially it is ascribed to subjective, widespread, miscalculation by financial institutions.[3] A related view is that the

fundamental factor is psychology.[4] Therefore, there is a widely asserted view that the key issue is ‘confidence' or 'lack of confidence’.

If any of the above were true then, although the present financial convulsion is severe, the adjustments that will follow will eventually be relatively minor. Once current psychology is reversed, that is ‘confidence is restored’, there can be a return to something approximating the previous situation – doubtless with some individual changes.

Such analyses are false. The present financial crisis is not rooted in psychology or subjective mistakes. It is rooted in long term economic trends. Its roots are therefore objective not subjective. Psychology is not driving the objective economic forces but following them.

The unfolding of the financial crisis does, however, show the importance of considering long term trends, and underlying developments, rather than merely considering short term shifts or individual facts taken out of context - as occurs in many newspaper commentaries. Misunderstanding of the preceding period, through failure to consider the overall situation, inevitably led to confusion regarding present events. 

The outcomes, and conclusions regarding the real driving forces of the present financial crisis, will be considered at the end of this article. First, however, the decisive data on the situation will be set out.

The most fundamental cause driving the present financial crisis was dealt with in a previous post on this blog - 'Why Asia will continue to grow more rapidly than the US or Europe'. This showed that the US now lags far behind the key Asian economies in the proportion of its economy which is invested - with a consequent continuing decline in the international competitiveness of the US economy.

This trend can be seen in Figure 1 - which is a simplified form of the graph in the previous post. It shows the investment levels (gross domestic fixed capital formation) as a proportion of GDP in the US, China and India. The US invests only 18-20 percent of its GDP whereas India invests over 30 percent and China more than 40 per cent. Similar, if less striking, graphs would show the same pattern for other key Asian economies. The result is China’s economy is growing at 9-11 percent a year, India’s at 7-9 per cent a year, and the US at only 3 percent a year.

Figure 1 

   

Given this US lag in investment, which is a key factor in competitiveness, the US economy, at any given exchange rate, becomes progressively less competitive over time. Consequently, given this decreasing underlying competitiveness, as long as the US does not raise its investment levels to that of other economies the only way for it to remain competitive is to steadily lower its exchange rate – that is to progressively devalue the dollar.

This declining competitiveness of the US economy is illustrated clearly in Figure 2, showing the US balance of payments. That the US runs a large balance of payments deficit is well known, but this graph shows the phases in the unfolding of that process.

Figure 2

• The US balance of payments first began to slide into sharp deficit in the early 1980s - the deficit initially reaching over 3 per cent of GDP by the mid-1980s

• There was a short lived recovery in the early 1990s - due to dollar devaluation, recession at the beginning of that decade, and a large one off payment from the Gulf states to finance the first Gulf war.

• This short recovery was followed by an even greater US balance of payments deficit after 1991 - which reached a peak of well over 6 per cent of GDP, or over well $700 billion a year, by 2006.

To show this development over a longer period Figure 3 shows net US ‘lending’ to the rest of the world since 1956 – a negative number showing US borrowing from the rest of the world. The deterioration of the competitiveness of the US economy is evident from these trends.

Figure 3

    

Given that the low US level of investment means the only fundamental mechanism by which it can remain competitive is dollar devaluation therefore Figure 4 shows the long term exchange rate of the dollar against two of the world's three most important non-US currencies, the euro and the yen - comparisons over the same period with the third, the yuan, are not meaningful as until the early 1980s China had an artificially set exchange rate which was not aimed at participation in international trade.

Figure 4

  

Three clear periods of developments in the US exchange rate are evident.

• From the immediate post-war period to the early 1970s the US maintained fixed exchange rates under the Bretton Woods currency system.

• From 1973 until the mid-1980s, via sharp short term fluctuations, a substantial dollar devaluation took place.

• From the mid 1980s onwards, while there were considerable short term fluctuations, and formally a floating exchange rate system operated, in fact the long term trend of the dollar’s exchange rate was stable.

The worsening US balance of payments situation, already shown in Figure 2, was an inevitable result of the the two circumstances which operated after the mid-1980s. The combination of

• a deteriorating competitiveness of the US due to its low investment rate

• a stable dollar exchange rate which prevented competitiveness being maintained by devaluation

necessarily meant an increasing movement into deficit of the US balance of payments - precisely as shown in Figure 2. In otherwords the dollar became progressively overvalued compared to the underlying competitiveness of the US economy.

The means whereby this dollar exchange rate remained stable, despite the worsening balance of payments deficit and the fact that the exchange rate was not formally fixed, is shown in Figure 5. Net foreign purchases of US debt instruments, Treasury Bonds and others, rose from around zero per cent of GDP in the early 1980s to 5.6 per cent of GDP in 2007 or $770 billion. The large inflow of investment in US debt instruments counterbalanced the deteriorating current exchange deficit to maintain a stable dollar exchange rate.

Figure 5

 

It is, however, impossible to cheat underlying economic forces. The history of all economies shows that attempts to artificially maintain a high exchange rate against the pressure of underlying economic forces will eventually fail. In short, at some point, there would inevitably be a dollar devaluation.

The consequences of an overvalued dollar for asset values denominated in dollars are also clear. The values of assets held in overvalued dollars are themselves necessarily overvalued in real international terms. There would, therefore, eventually be a revaluation of such assets downwards to their real, that is lower, values.  As that downward revaluation takes place it will erode or destroy the balance sheet of the institutions holding such assets – this is the process which is at present occurring, unleashing the wave of bankruptcy of US financial institutions.

As the dollar devalues, and assets decline towards their real competitive values, two other processes occur. 

• Foreign holders of dollar assets suffer losses – given that last year alone such inflows, as noted, amounted to $770 billion in US debt instruments any such losses would be large. Japan is estimated to hold $860 billion in US debt instruments, including Treasury Bonds and $75 billion in debt issued previously by the recently nationalised US mortgage institutions Fannie May and Freddie Mac. China is estimated to hold large quantities of US Treasury Bonds and up to $400 billion in Fannie Mae and Freddie Mac debt.

• Given the decline in the value of US assets, a political struggle breaks out between different groups in the US population over who will bear the cost of such a fall.

Given the preceeding overvaluation of the dollar it is inevitable that such shifts should take place. In essence the current financial crisis in the US is a classic one of the attempt to maintain an overvalued exchange rate - the type of crisis which affected Mexico in 1982, Russia in 1998, or Argentina in 2001. In each of these cases the inevitable collapse of the attempt to maintain an overvalued currency wrought havoc on the financial institutions of the country concerned.  In the case of the US the fact that its economy is on a much larger scale, and plays a pivotal role in the global economy, makes the consequences of such a crisis far more severe.

Why, however, If the crisis is of a rather classical form is there confusion over its driving forces - of the type outlined at the beginning of this article?

The confusion has arisen because a number of commentators in the preceeding period, instead of considering  fundamentals and overall trends, took individual facts out of context and created a false ‘narrative’ regarding developments. This perspective was that the US economy was becoming more competitive - to the point where it had created a ‘new economy’. This false perspective was rationalised by looking at a few individual sectors, notably high technology, in which the US is indeed highly competitive. But, as shown in the balance of payments figures, overall the US economy was becoming less, not more, competitive.

The financial crisis is therefore not rooted in psychology nor in short term developments. It is rooted in objective economic processes operating over long periods. The outcome and unfolding of this crisis will, however, be determined by political factors.

The interrelation of these economic and political elements will be looked at in a future post. But the fundamental factors in the situation are clear and flow from the above trends.

If the US were to seek to achieve a level of investment to match its Asian rivals this would, in the short term, due to the huge transfer of resources from consumption to investment that would be required, unleash a wave of popular discontent in the US that would destabilise the political situation - for that reason it is highly unlikely to occur in the short term. The only other way to restore competitiveness in the short term, that is dollar devaluation, would cause radical financial destabilisation as the value of dollar assets declines - destroying the balance sheets of financial institutions holding such assets.Either course will produce strong pressure on the living standards of the US population and therefore have major political impact in the US.

 

References - for detailed references see continuation of article

Why Asia will continue to grow more rapidly than the US and Europe - a historical perspective

 

Data on long term trends in investment and economic growth

This post deals with the historic trend of investment and economic growth. This may appear a relatively esoteric topic. In fact, however, it has decisive economic and strategic business consequences - in particular for understanding the more rapid growth of the key Asian economies relative to the US and Europe and why this will continue for a prolonged period. Before dealing with these and other more detailed implications, however, the factual data is set out.

Figure 1 shows the percentage of fixed investment (gross fixed capital formation) in GDP for a series of major countries over the longest periods of time for which data is available. [1]

 

Figure 1

The pattern is clear and striking. By far the strongest trend is for the proportion of GDP devoted to fixed investment (gross domestic fixed capital formation) to rise with time. This in turn, as will be shown, is associated with progressively rising rates of economic growth.

Considering countries in the chronological order in which a new peak in the proportion of GDP devoted to gross fixed domestic capital formation appeared the following is the historical pattern.

·        Commencing with the period immediately antedating the industrial revolution, the proportion of GDP devoted to fixed investment in England and Wales, at the end of the 17^th century, was 5-7 per cent. [2] This rose slightly, although current estimates are that it did not rise greatly, during the 19^th century - peaking at over ten percent of UK GDP prior to World War I. 

This level of investment was sufficient to launch the first industrialisation of any country but at a rate of growth which, while unprecedented at the time, was extremely slow by contemporary international standards - about two per cent a year. With such a growth rate it takes 35 years for an economy to double in size and 70 years to quadruple.

·        Turning to the latter part of the 19th century, the proportion of US GDP devoted to fixed investment had risen to considerably exceed that for the UK – reaching a level of 18-20 per cent of GDP by the last decades of the century.

A sharp fall in the proportion of the US economy devoted to fixed investment commenced in the late 19^th century, and was particularly pronounced during the period between World War I and World War II – being associated with the great depression of the inter-war period. After World War II the US resumed its pattern of 18-20 per cent of GDP being devoted to gross fixed capital formation. This generated an average growth rate of 3.5 per cent a year. With such a growth rate an economy doubles in size every 20 years and quadruples in size every 40 years.  It was on the basis of this historical level of investment, and growth rate, that the US overtook Britain to become the world’s greatest economic power.       

·        In the period following World War II Germany achieved a level of fixed investment exceeding 25 per cent of GDP – peaking at 26.6 per cent in 1964. This period 1951-64 was that of the post-war German ‘economic miracle’ with average growth of 6.8 per cent a year - with such a growth rate an economy doubles in size every 11 years and quadruples in 22 years. 

·        Starting at the beginning of the 1960s Japan achieved a level of gross domestic fixed capital formation of more than 30 per cent of GDP. This reached a peak in the early 1970s, at 35 per cent of GDP, before later sharply falling. During that period the average annual rate of growth of the Japanese economy was 8.6 per cent. With such a growth rate an economy doubles in size in eight and half years and quadruples in size in 17 years.

·       From the 1970s onwards, South Korea similarly achieved a level of fixed investment of 30 per cent of GDP. During the 1980s this rose above 35 per cent of GDP.  The other East Asian ‘Tiger’ economies – Singapore, Hong Kong and Taiwan – showed a similar pattern.  South Korea’s economy confirmed the relation between fixed investment and economic growth illustrated by Japan by growing in this period by an average 8.3 per cent a year. At such a growth rate an economy doubles in size in nine years and quadruples in 18.

Such growth rates in Asia showed that something unprecedented in human history was now possible – that it was possible to industrialise an economy, and achieve a ‘first world’ level of development, in a single generation.

·        From the early 1990s onwards China achieved sustained rates of fixed investment of 35 per cent of GDP with, from the beginning of the 21^st century, this rising to more than 40 per cent of GDP – a level never before winessed in human history. The result was average 9.8 per cent a year economic growth over a sustained period – also the most rapid sustained economic growth ever seen in human history. On that basis an economy doubles in size every seven and a half years and quadruples in size in 15 years.

·       To complete the chronological picture, the proportion of GDP devoted to fixed investment for two countries recently undergoing rapid economic growth, India and Vietnam, is shown.

The proportion of Indian GDP devoted to fixed investment has not reached the Chinese level but has become high – reaching 34 per cent of GDP in 2007. On this basis, in the last five years, India has achieved an average growth rate of 8.8 per cent a year. At that rate of growth India’s economy doubles in size in slightly over eight years and quadruples in sixteen and a half years.

In Vietnam the proportion of GDP devoted to fixed investment rose from 13 per cent in 1990 to 25 per cent in 1995 to 37 per cent in 2007. Economic growth has accelerated rapidly, rising to an average of 7.9 per cent a year in the five years up to 2007. At that rate of growth Vietnam’s economy doubles in slightly under 9 years and quadruples in size in 18 years.

Considering these trends, such a high level of investment is a necessary condition for rapid economic growth. No substantial country without comparable high levels of fixed investment has achieved such rapid rates of growth on a sustained basis. [3] But it is not a sufficient condition: the high level of investment is also linked to the scale of production, that is the size of the market being produced for. In a modern economy only large scale production can be efficient in the decisive sectors of production, requiring an orientation to the international market – this is particularly evident with such high levels of investment.

No purely national market, not even the US or China, is sufficiently large to maintain the most efficient level of production. As many others have frequently correctly stressed, high levels of investment must therefore be accompanied by an export orientation. [4] It is this high level of investment, accompanied by an export orientation, which was responsible for the rapid economic growth of South Korea, China, India and Vietnam.

Implications of different investment levels

There are a number of clear consequences of these factual trends (it must be stressed that this data, of course, deals only with long and medium term trends and is not a guide to short term fluctuations).  Among the most important of these implictions are:

·         It provides a clear historical framework for understanding the present rapid growth of (primarily Asian) economies and why they will continue to grow far more rapidly than the US and Europe. 

·        China’s economy will continue to outperform India’s and the gap between the two will grow - and not shrink as some have suggested.

·        There is no serious historical evidence for the thesis sometimes presented that China is oversaving/overinvesting. China therefore should seek to maintain, and not cut, its current savings and investment levels.

·        Current US/UK economic policy, with its overwhelming emphasis on microeconomic efficiency of resource allocation, fails to address the most important economic issues and therefore will be unsuccessful – which will deepen the tendency for the key Asian economies to grow more rapidly than the US and Europe. The also provides a background to current issues in the credit crunch.

Taking these issues in more detail:

First, these trends place in wider historical context the present rapid growth of a number of (primarily Asian) economies. The latter represent the latest high point in the trend for higher and higher proportions of GDP to be devoted to fixed investment. Consideration of such trends therefore provides a clear theoretical underpinning for the evident current empirical fact that not only is Asia growing substantially more rapidly than the US and Europe but that it will continue to do so. The investment rates in the key Asian economies are not aberrantly high but merely the latest point in an historical trend.

Seen in long term historical perspective it is US and European savings and investment rates that are too low, not Asian savings and investment rates that are too high. 

Second, given these historic trends, it is clear that on the basis of current macroeconomic trends China’s economy will continue to expand more rapidly than India's and that China will increase its economic lead over the latter.

This naturally does not mean anything other than that India is an extraordinarily important market. India’s economy is, at a realistic exchange rate, in Parity Purchasing Power (PPP) terms, the fourth largest economy in the world after the US, China and Japan.[6] India's economic  growth, running at around at 8-9 per cent a year, is the second largest for any major economy in the world after China. However, China’s economy is already approximately two and a half times the size of India’s in PPP terms and is continuing to grow at one to two per cent a year more rapidly than India – this combination ensuring that the gap between China and India is widening and not narrowing.

There is also no evidence from consideration of historical data that the factors invoked to claim that India’s economy will grow more rapidly than China’s, for example different demographic profiles, are crucial. The historical evidence is that it is the proportion of the economy devoted to gross fixed capital formation that is decisive. The fact that, until the present, the Chinese economy continues to devote a significantly higher proportion of the economy to fixed investment than India – 43 per cent compared to 34 per cent to take the latest available years, indicates that unless India catches up with China in terms of this area China will grow more rapidly than India.

Third, there is no evidence from this historical trend data for the argument that China is facing a basic crisis of oversaving/overinvestment, and therefore that China needs to lower its total savings level (i.e. savings including private, public and corporate saving) and to increase consumption - as some commentators, including the Financial Times chief economics commentator Martin Wolf, have stated. [5]

It is evident that China’s level of investment and saving is far higher than that of the US or UK. However the historical data make clear that China’s is simply the latest stage in the long term trend for an increasing proportion of GDP to be devoted to gross fixed capital formation. Given this rising historical trend it is entirely likely that in the future another country, or China itself, will have a higher proportion of GDP devoted to saving/investment than China today - yielding a higher rate of growth. 

While, of course, short term fluctuations and adjustments may be required there is no historical evidence that China's savings and investment rate is excessively high - it is merely the latest stage in a long term international historical trend. Reduction of China’s investment and savings rate would lead to slowdown not only of China’s economy but also, because of its locomotive role in the world economy, a slowdown in the global economy. China should therefore be seeking to maintain, not reduce, its current high investment and savings levels.

Fourth, there is no evidence from the historical data that the 'quality of entrepreneurship' plays any crucial role in economic development. Or more precisely, and what is another way of saying the same thing, the quality of entrepreneurship and managerial effectiveness appears to be randomly distributed and therefore cannot explain differences in economic growth rates. There are no cases where, due to the 'quality of entrepreneurship', countries have experienced rapid growth without high levels of gross domestic fixed capital formation in GDP.

Fifth, present US/UK government economic policy, by according overwhelming centrality to dealing with microeconomic efficiency, is addressing relatively minor issues in terms of international competitiveness compared to that of dealing with inadequate saving and investment rates. The economic priorities of a number of rapidly growing Asian economies will therefore clearly be more effective than that of the US and UK.

Put in other terms, the implications for governments’ economic policies of the long term trends outlined here is that in a balance between seeking microeconomic efficiency in the allocation of resources,  and seeking a high level of savings and investment, the high level of savings and investment is more important that the emphasis on microeconomic efficiency  from the point of view of creating economic growth.

There is an entirely reasonable supposition that the microeconomic allocation of investment in South Korea or China, given the use of subsidised loans, cross forms of ownership in different branches of industry, higher capital/output ratios etc, is less microeconomically efficient than in the UK or the US.  However the rate of growth of the South Korean or Chinese economies is much more rapid, over a sustained period, than that of the UK or US.

Quantitatively the greater microeconomic efficiencies in allocation of resources in the US or UK, to generate an equal rate of growth, would have to compensate for their lower savings and investment ratios and there is no evidence that it does so. It is the higher savings and investment rates in Asian economies that predominate over greater microeconomic efficiency.  Therefore any quality of microeconomic priorities in the US and UK will be overwhelmed by the quantity of investment in the rapidly growing economies of Asia.

Ideally, of course, both high microeconomic efficiency and high savings/investment levels should be sought. However there is evidence that the two are contradictory. For example  the policies pursued in the US and UK have been accompanied by massive declines of savings rates which have undermined the competitiveness of the economy – leading into present sharp financial problems.  It is therefore likely that current US and UK economic policy will be unsuccessful, and these economies will remain under financial pressure created by lack of competitiveness for a prolonged period. The credit crunch is a one periodic form of the manifestation of this loss of competitiveness by the US and UK.

 

Conclusions

The following clear conclusion may be drawn from this data:

There is a clear historical trend for the proportion of the economy devoted to gross domestic fixed capital formation to rise. This is the key determinant of rising rates of economic growth.

Five key historic stages in the rise in this proportion of the economy devoted to fixed investment may be identified: the achievement of a 5-7 per cent investment rate in Britain in the 18th century permitting the launching of the industrial revolution; an 18-20 per cent of GDP fixed investment rate from the latter part of the 19th century, achieved by a number of countries led by the US, which permitted the United States to replace the UK as the world's leading economic power; a 25 per cent of GDP fixed investment rate in Germany in the immediate post-World War II period which accompanied the German 'economic miracle'; a more than 30 per cent of GDP rate of fixed investment achieved in Japan, and then the other East Asian 'Tiger' economies, from the mid-1960s which permitted growth rates of more than 8 per cent a year; a more than 35 per cent of GDP fixed investment rate in China from the 1990s onwards which has permitted sustained growth rates approaching 10 per cent a year.

On the basis of this differential in investment rates a number of the key Asian economies will continue to outperform the US and Europe in terms of economic growth for a prolonged period.

China will continue to increase its economic lead over India - although the latter will experience rapid economic growth.

There is no historical evidence China is oversaving or overinvesting and it should seek to strategically maintain, and not cut, its present investment and saving rates.

Current US and UK economic policy addresses secondary issues and therefore is unlikely to be successful.

Note on future postings

The current blog Key Trends in Globalisation is intended to be accessible to readers without  specialised economic knowledge and for those who do not necessarily wish to be follow detailed economic issues. The current post is placed here because the issue its deals with are of very great importance for understanding current trends in the world economy.
A companion blog Key Trends in the World Economy has therefore been established to deal with a wider range of economic issues. Notification of links to posts on Key Trends in the World Economy will be given on the current blog. But the full posts will not be reproduced here in order to maintain accessibility.

References - for detailed references see continuation of article