Bill Emmott - International Author & Adviser


How and why the global economic crisis happened
Voice - 2009

The global economic recession of 2007-2009 proved to be both unusual and remarkable. It was unusual, first of all, in its global reach: previously, there has always been some substantial part of the world economy that has remained healthy while others are in recession—indeed, from the 1950s until the 1990s, that exception was usually Japan. But the economies of China and India are still too small, and their growth in imports too weak to provide such support.

The recession was also unusual, at least for the rich West European and American economies, in the fact that the downturn was caused by financial shocks and collapsing demand rather than by deliberate anti-inflationary policy, as has generally been the case in recessions since 1945. Only Japan among the rich economies is accustomed to this sort of downturn, and in its case only because of the post-bubble crash of the 1990s.

For the poorer and emerging economies, however, the recession or sharp slowdown was quite different, even though it was more or less synchronized with the rich-country slump: China, India and other emerging economies had a much more conventional cycle begun by a surge in inflation in the first half of 2008, which prompted both countries, and many other Asian economies, to implement tough anti-inflationary policies. Then the slowdown caused by those policies was compounded by the slump in world trade after Lehman Brothers went bust in October 2008; and poorer countries, in Africa and Latin America especially, suffered from the drop in Chinese and Indian imports of raw materials.

Thus, synchronized as it was, the recession of 2007-09 differed greatly in different parts of the world and for different types of economy, which is also why the recoveries we have been seeing in the second half of 2009 have also varied greatly around the globe.

Most of all, though, and despite that variety, this recession was remarkable in its suddenness and sharpness: from October 2008 onwards much of the world economy felt as if it had fallen off a cliff, such was the severity of the decline in demand during the ensuing six months. That period was truly shocking and frightening. The good news is that the shocking period seems to have come to an end. The shocks are over. Most economies are recovering. But the pain is not over. For the effects of this slump will last a long time.

            These unusual and remarkable features have made this recession an especially hard one to analyse, to adjust to and indeed to predict, just as it is now difficult to predict the shape and duration of the recovery. After all, a corporate and financial world which in the West in many respects had become more open and transparent in the past decade has suddenly been badly damaged by the collapse of a "shadow banking system" of debts and securities whose magnitude, nature and global extent were largely unknown, both to regulators and to participants.

Although government policy in America, Europe and Japan has reacted rapidly to that sudden collapse with an extraordinary series of ambitious and largely unprecedented measures, it is not possible to be sure that new surprises do not await us, especially in those parts of the financial sector that continue to be hidden from sight, lacking clarity and transparency. Political surprises could also arise, anywhere around the world, given the ever-changing public and political responses to rising unemployment, to the substantial cost to taxpayers of rescuing the financial system, and to fear of the future consequences of rising public indebtedness and rising tax burdens. Moreover, following this shock and given the special financial circumstances of the Western recession, psychology is going to play a crucial role during the recovery. Will American and European companies and consumers decide to resume their old borrowing and spending habits as their economies recover? Or will they change their ways, feeling that high debts and high spending is too dangerous in the new world? We cannot know the answer in advance.

A foggy future for the world economy

So, in this highly uncertain economic climate, where can we expect the world economy to head? This first chapter of the book will be devoted to understanding the crisis but also to offering some thoughts on where the world economy might go from now on. Later chapters will examine the implications for international finance and for currencies, as well as the environment, the future of capitalism and the future of Japan itself.

The proper way to examine the future of the world economy is not by simple prediction, since at such turbulent times predictions are bound to be proved wrong. The better approach is to offer an analysis of probabilities, risks and possible global policy implications. To make such an analysis, we can take some economic and philosophical guidance from what might perhaps be a surprising source: the man who was President George W. Bush´s Secretary of Defence, Donald Rumsfeld.

            The disastrous aftermath of the American invasion of Iraq shows that Mr Rumsfeld was a failure as a Defence Secretary. But he was nevertheless a wise analyst. At least, he showed great wisdom in one of his most widely quoted press conferences. In that press conference, in 2002, Mr Rumsfeld said that we should be careful to distinguish between those things that we know for certain and those that are much less certain. He described the first category as "known knowns", and the second category as "known unknowns". This second category is really one of known risks or known potential upsides and downsides. He also had a third category: "unknown unknowns", or things that had such an unlimited capacity to surprise that we truly should admit that we know nothing about them.

            When looking at the global economy, I think we can limit ourselves to the first two categories: known knowns, and known unknowns, or clear facts and evident risks. Let us start by trying to list the clear facts about the global economy.

            The first clear fact, or known known, is that slumping private demand has been replaced, or at least been compensated for, by increasing public demand, and private debt has been replaced by public debt, all over the world but especially in America, Europe and Japan.  The response of governments to the sudden collapse in private demand that began in October 2008 has been consistent in direction, if not in magnitude: to cut taxes, increase public spending and increase public borrowing in an effort to replace that fall in private demand. In America and Britain, the governments´ budget deficits are forecast to reach 12-14% of GDP in 2010, the highest since 1945; in the Euro-zone countries, deficits are expected to reach 5-8%; in Japan the deficit will approach 8% or even more. Among the world´s poorer countries, those governments that can afford to increase their borrowing are also doing so. China´s government budget deficit is moving from a small surplus in 2008 to a deficit of perhaps 5% of GDP in 2009; India´s budget deficit is increasing from 6% of GDP in 2008 to perhaps 10-12% this year.           

            These increases in public borrowing are being financed chiefly from the capital markets but also through money creation by central banks. In the current deflationary circumstances, with private borrowers reducing their debts, this vast amount of public borrowing is unlikely to "crowd out" private borrowers and force interest rates higher. But as and when economies recover and private demands for funds increase, such crowding out is quite likely. Hence the cost of long-term debt can be expected to rise, both for governments and for companies.

            The second known known follows logically from the first. It is that in the medium term, which probably means from 2011 until 2015, in many countries taxes will rise and public spending will be cut, in order to gradually reduce these fiscal deficits.  In Japan during its 1990s post-bubble stagnation, the government sought to raise taxes and begin "fiscal consolidation" whenever it thought a recovering economy would make that possible. The same is likely to be true in America, Western Europe and probably China and India, as well of course as in Japan. Those fiscal consolidation efforts will have the effect of restraining economic growth. They will not prevent growth altogether: but it will be slower than it otherwise would have been.

            In one sense, this is quite just, in a moral sense. A surprising feature of the 2007-09 recession has been that the social and political effects of it have been fairly mild: few riots, little increase in social or political instability in all the rich developed countries. That might suggest that the worst recession since 1945 has somehow not been painful. But that would be wrong: the pain will in fact be spread out, from 2011 until at least 2015, in the form of higher taxes and reductions in public services.

            There is, however, a complication for this picture. It is that the third known known is the fact that in the world´s three biggest economies, the expansionary fiscal policies of 2008-09 are likely to be reinforced by a longer-term, structural effort to expand government and especially social spending, pushing in the opposite direction from fiscal consolidation. We know that President Barack Obama has tabled an ambitious proposal to expand federal and state spending on health care in America, in order to ensure that the 40m Americans who are currently uninsured in private plans can secure health coverage, and he wants to increase spending on education too. In Japan, the new DPJ government that took power after the Lower House election on August 30th last year wants to bring about a major expansion of social spending, especially on unemployment insurance and health care. And in China, the Communist Party has promised a huge expansion of government spending on health care, education, pensions and other social spending, in order to reduce public fears about inequality, over-stretched health clinics and retirement pensions. Some of this effort in America and Japan will occur by reallocating spending rather than by increasing it, but by no means all of it.The result of these moves will be that the share of GDP accounted for by taxes and public spending will rise in all the world´s top three economies, from 30-35% of GDP in the USA and Japan, and from 20% of GDP in China.

            As the recovery gets under way, governments are hoping that banks will increase their lending, helping companies and consumers to spend more. But this is likely to be countered by the fourth known known, that lenders and investors are now going to be risk-averse and cautious during the recovery.  Although governments will say they are annoyed by this attitude, actually they will partly be responsible for it. Banks and other financial institutions have suffered big losses thanks to their past under-estimation of risk, so for several years to come they are likely to swing towards the opposite pole, of over-estimating risk and thus being extremely risk-averse in their lending and investment policies. Regulators will require banks to hold larger capital cushions, which will raise banks´ costs and limit their lending. That will be a deliberate policy of reducing risk and rebuilding the profitability and capitalization of banks. The consequence will be to slow the recovery in lending.

            Whether or not companies really want to borrow money will depnd on the fifth clear fact. This is that, as the recovery has begun, deflation, ie falling prices and wages, is a stronger and more widespread force than inflation.  Weak demand for goods, services and credit, amid conditions of global over-supply and over-capacity, will tend to keep prices depressed, in the developed world. Only a sharp economic recovery could be expected to change that. There is some cause to fear that huge public deficits and central bank money-creation could eventually become inflationary. It is likelier, however, that the first signs of inflation will prompt a sharp rise in bond yields as investors demand compensation for future inflation and as they came to expect "crowding out" of private borrowing by the vast amount of bonds being issued by governments. This rise in long-term borrowing costs would in turn choke off any sharp recovery, returning economies either to slow growth or a fresh recession.

            In the emerging economies of China and India, things look likely to be different. There, thanks to rapid monetary growth and to the fact that demand for goods and services has rebounded strongly, thanks to the lack of any depressing financial collapse, inflation is a much bigger danger. Rising food and oil prices are contributing to this. So having had a synchronized recession or slowdown, the world might now have a divided recovery in terms of deflation and inflation: deflation, or else price stability, in America, Europe and Japan; inflation in China, India and some other emerging economies.

            Over-capacity is particularly a feature of manufacturing industry. Those big economies in which manufacturing industry and manufacturing exports play a large part were the worst hit during the first six months of the global recession. That was the problem faced by Japan and Germany among the rich countries, but also such Asian economies as Taiwan, South Korea, Malaysia and Singapore. The shock of financial collapse in September-October 2008 led companies and households to cut dramatically their purchases of consumer durable goods such as cars and electronic goods, and of industrial machinery such as robots and machine tools. As demand had anyway weakened ahead of the financial shock, producers of manufactures found themselves carrying inventories of components, materials and finished products that were far too large. So they had to cut their output even more sharply than was required by the drop in final consumer and corporate demand, in order to reduce their inventories.

            In the early months of recovery, however, this amplifying effect of manufacturers´ inventories went into reverse. Producers found their inventories too small, and so started increasing their production faster than was dictated by any recovery in demand. As a result, although Germany, Japan and other manufacturing countries have been hit hardest in the 6-9 months from October 2008 onwards, they also enjoyed a faster and stronger recovery in mid-2009, as manufacturing output rebounded in order to rebuild inventories. That inventory effect will not last for long, however. And during 2010 these big manufacturers are again likely to feel the deflationary impact of excess capacity on producers´ pricing power.

            These last two points, of inflationary forces in the developing world and a rapid inventory-led rebound for manufacturing countries combine to produce the seventh, and last, known known: that among poorer or emerging economies, those in which domestic demand can be strengthened and which have stable sources of domestic finance have proven better able to withstand the global recession, and are likely to experience a faster and stronger recovery.

            This means China and India can and will perform better than the rich nations during the next few years. Both China and India suffered a halving of their growth rates in 2008-09, followed by quite a strong rebound. Their high domestic savings rates, combined in China´s case with a strong fiscal position, can be expected to enable them to recover and maintain moderate levels of growth independently from any revival in global trade. China, despite its high level of exports, has been less affected by the collapse in global trade than other manufacturing countries (such as Japan, Korea and Germany) because much of its export manufacturing sector consists of low value-added assembly operations with a high import component. Now, its economy promises to emphasise domestic demand more than exports, though principally domestic public-sector demand (eg, health care and infrastructure) rather than consumer demand.

            These seven known facts combine to indicate that the rich developed countries should now expect a shallow, weak economic recovery, with some risk of a lengthy macroeconomic stagnation. High taxes, public debts and rising long-term interest rates are all likely to weigh down heavily upon the rich economies during the next few years. China and India can and will grow more rapidly, but they cannot expect to be helped by strong import demand for goods and services from the rich countries, and do face some risks of inflation.

The big risk factors

Secretary Rumsfeld also warned, however, that there are not only "known knowns" but also "known unknowns". Some important risks and uncertainties hang over even this quite pessimistic prediction of the future.

            Chief among those unknown factors or risks are the psychological factor mentioned earlier. Technically, this is known as the strength and duration of deleveraging by households and by companies, all over the rich world. For it is psychology that will determine households´ and companies´ attitudes to debt.

            We know that the world got into this problem thanks to the excessive creation of debt. This debt, ultimately, was held by households and companies. In America and Britain, for example, household savings fell to zero, as a percentage of their disposable income, or even to a negative, as debts and debt-servicing exceeded incomes. Shocked by the financial collapse, by rising unemployment and by the tightening of credit conditions, households in these high debt/low savings countries are cutting back their spending and increasing their savings. But consumers are also doing the same in high savings countries such as Germany and Italy. Companies meanwhile are doing the same: trying to reduce their debt exposures. The big unknown is how far this will go and for how long it will last.

            The experience in Japan during the 1990s is that companies there carried on cutting their debts, and thus their capital investment and other spending, for a very long time, well into the beginning of the current decade. This had the effect of weakening the economy and reinforcing deflation. If the same sort of debt-reduction trend takes hold in many rich countries during this global downturn, then the stagnation could last a long time or we could even see a new recession. Alternatively, if consumers and households start to feel confident about economic stability and recovery, they may prove to be happy with just a moderate adjustment of their savings and debts. Since this is in the realm of psychology, economists have no chance of forecasting this crucial element of consumer and corporate behaviour.

            What they can do however, is to say that one determinant of that psychology will be perceptions of financial stability. In Japan in the late 1990s, the banking and insurance companies still looked very sick and unstable. Corporate borrowers could not be sure whether their main source of finance, the banks, were going to survive or not, or whether they might take a tough new approach to their debtors. So it was rational to act prudently by reducing debt exposures. The same question exists today, in America, Europe and even Japan. Are the banks stable? Have the public recapitalization and clean-up efforts gone far enough?

            My guess is that in America and Britain, the use of public capital and the start of forced clean-ups of toxic assets has been quicker and more decisive than was the case in Japan during the 1990s. So confidence in those countries´ banking systems should recover quite quickly. I am less sure about some other European countries, especially Germany, Hungary and other places in central and eastern Europe. Doubts over bank stability in Europe look like persisting far longer than in America, Britain or indeed Japan.

            A further big source of risk and uncertainty concerns the prices of oil and other commodities. Their prices collapsed from July 2008 until April 2009, with oil dropping spectacularly from $150 a barrel to just $35. Since then, however, oil prices have begun to rise again despite the fact that global demand remains very weak, and the same has happened for other commodities such as copper and iron ore.  It is rather extraordinary that, after the worst global recession since 1945, oil prices in the autumn of 2009 nevertheless reached $70-80 a barrel, well over double their level in March of that year, and nearly ten times higher than in 1997-98.

            This may be because consuming countries have been rebuilding their inventories of these resources. Or it may be because supply is even scarcer and more strictly controlled by producers than we thought. In any case, the risk persists of a new sharp rise in oil and commodity prices, which would give a harsh blow to the economies of major consuming countries, such as Japan and America.

            High oil prices, as a later chapter will argue, could help reduce consumption of all fossil fuels and thus speed the world´s transition to a low-carbon economy. That would be beneficial in the longer term, and for the stability of the global climate. But it would be costly, and would represent a further reason to expect only slow growth in the coming five years or more.

            Then, there is always the known unknown of politics. Domestic political pressures, in response to recession and rising unemployment, tends to lead to increased protectionism and restrictions on trade. There has been some minor tendency towards protectionism already. What we don´t know is whether a long stagnation might lead to more substantial protectionist measures, which could damage world trade.

            International politics is also a risk: tension or even conflict between the major powers, especially China and America, would be extremely damaging to economic recovery. This does not look likely. But it could occur at short notice, over such unstable places as North Korea, Pakistan or even Tibet. Moreover, domestic politics can produce instability or regime change that leads to international consequences, even in relatively developed countries. In the Asian crisis of 1997-98, the political surprise came in Indonesia, where the dictatorship of Suharto was overthrown, ultimately with benign results. But a more malign outcome is also possible, if for example we see major political instability in poorer European countries such as Greece, Hungary or the Baltic states, or in Russia. Or somewhere else that surprises us. Surprises are always possible, of course. But periods of great economic stress make surprises likelier.

            Finally, let me emphasise one type of political risk that we have already seen in the past decade: a major terrorist attack on the American mainland—or indeed on the mainland of any of the world´s leading powers. The atrocity of 9/11 prompted wars in Afghanistan and Iraq. A future atrocity could prompt a war in Pakistan, which is a nuclear-armed state, adjoining two great powers, namely China and India. A future atrocity in which terrorists used nuclear, radiological or biological weapons, successfully causing major loss of life, would have huge political implications. Of course, the tragic loss of life would be shocking, but most terrorist attacks do not fundamentally change the way societies operate. A nuclear or biological attack might well bring about fundamental changes, by leading governments to rethink the benefits of open borders, for example, of globalization itself, of the free movement of people. This is an extreme case that is, we can say, fairly unlikely. But it is certainly not impossible. Who would have predicted, in January 2001, then nine months later terrorists would succeed in hijacking four aircraft and crashing them into the World Trade Centre in New York, the Pentagon in Washington and (the one failure, since its true target is thought to have been Capitol Hill or the White House) the ground in Pennsylvania?

            What a depressing note on which to end a chapter.


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