1. 1 Jeffrey Frankel Harpel Professor of Capital Formation and Growth China Future Leadership Project Feb.3, 2009 The Global Economic Situation

2. 2 Topics 1. How a US financial crisis turned global recession. 1.Origins 2.US recession 3.Policy response: monetary, banking, fiscal 4.Spread to the rest of the world 5.Forecasts 6.Emerging markets 2. The longer-term problem of US-China symbiosis 1.US deficiency of national saving 2.The RMB and complaints from US politicians 3.Will the $ stay the top international reserve currency?

3. 3 The return of Keynes Most economists still shy away from using the name. Most economists still shy away from using the name. But Keynesian truths abound today: But Keynesian truths abound today: –Origins of the crisis –The Liquidity Trap –Fiscal response –Motivation for macroeconomic intervention: to save market microeconomics –International transmission & coordination

4. 4 Origins of the Crisis At Davos last week, the leaders of China and Russia chastised the United States for having been the source of the global recession, At Davos last week, the leaders of China and Russia chastised the United States for having been the source of the global recession, in fitting retaliation for lectures from the US leaders ten years ago, to emerging market governments, that they should emulate the US financial system. in fitting retaliation for lectures from the US leaders ten years ago, to emerging market governments, that they should emulate the US financial system.

5. 5 Onset of the crisis Well before 2007, there were danger signals in US: Well before 2007, there were danger signals in US: –monetary policy too easy 2003-04… –flawed corporate governance –underestimation of risk –housing prices too high, –National Saving low, –current account deficit, –excess leverage, –imprudent mortgages…

6. 6 Origins of the crisis The crisis was a burst asset bubble, loss of confidence, credit crunch. The crisis was a burst asset bubble, loss of confidence, credit crunch. More like Keynes’ animal spirits or beauty contest than like Friedman-Schwarz More like Keynes’ animal spirits or beauty contest than like Friedman-Schwarz It was not a monetary contraction in response to inflation (as were 1980-82 or 1991). It was not a monetary contraction in response to inflation (as were 1980-82 or 1991). But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices. But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices.

7. 7 Onset of the crisis Initial reaction to troubles: Initial reaction to troubles: –Reassurance in mid-2007: “The subprime mortgage crisis is contained.” It wasn’t. –Then, “The crisis may stay on Wall Street, sparing Main Street.” It didn’t. –Then de-coupling : “The US turmoil will have less effect on the rest of the world than in the past.” It hasn’t. By now it is clear that the crisis-turned- recession is as bad abroad as in the US. By now it is clear that the crisis-turned- recession is as bad abroad as in the US.

8. 8 US Recession In December 2008, the NBER Business In December 2008, the NBER Business Cycle Dating Committee proclaimed the US peak had occurred December 2007. Recovery unlikely before late 2009. Recovery unlikely before late 2009. –Housing starts at record lows. –Confidence at record lows… => Recession is longest since 1930s. => Recession is longest since 1930s. Could well be as severe as 1980-82. Could well be as severe as 1980-82.

9. 9 BUSINESS CYCLE REFERENCE DATES Source: NBER Source: NBER PeakTroughContraction Quarterly dates are in parentheses Peak to Trough August 1929(III) May 1937(II) February 1945(I) November 1948(IV) July 1953(II) August 1957(III) April 1960(II) December 1969(IV) November 1973(IV) January 1980(I) July 1981(III) July 1990(III) March 2001(I) December 2007 (IV) March 2001 December 2007 March 2001 December 2007 March 1933 (I) June 1938 (II) October 1945 (IV) October 1949 (IV) May 1954 (II) April 1958 (II) February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) March 1991(I) November 2001 (IV) March 1991 November 2001 March 1991 November 2001 43 13 8 11 10 8 10 11 16 6 16 8 8 Average, all cycles: 1854-2001 (32 cycles) 1945-2001 (10 cycles) 17 10

10. 10 US employment peaked in Dec. 2007, which is the most important reason why the NBER BCDC dated the peak from that month. Since then, 2 ½ million jobs have been lost. Payroll employment series Source: Bureau of Labor Statistics

11. 11 Recession was soon transmitted to rest of world: Contagion: Falling securities markets & contracting credit. Contagion: Falling securities markets & contracting credit. –Especially in those countries with weak fundamentals: Iceland, Hungary & Ukraine… –But even in some where fundamentals were relatively strong: Korea… Some others are experiencing their own housing crashes: Ireland, Spain… Some others are experiencing their own housing crashes: Ireland, Spain… Recession in big countries will be transmitted to all trading partners through loss of exports. Recession in big countries will be transmitted to all trading partners through loss of exports.

12. 12 Forecasts

13. 13 OECD forecasts showed its growth approx. flat in 2009 Source: OECD Economic Outlook (Nov. 2008).

14. 14 Similarly, World Bank forecasts showed rich-country growth flat in 2009. World 4.0 3.7 2.5 0.9 3.0 Memo item: World (PPP wts) 5.0 4.9 3.6 1.9 3.9 High-income countries 3.0 2.6 1.3 0.1 2.0 2006 2007 2008* 2009† 2010† Developing countries 7.7 7.9 6.3 4.5 6.1 Estimated † Projected Source: World Bank, Jan. 2009 (% change from previous year)

15. 15 have now downgraded again (Jan.28, 09)

16. 16 The IMF has revised growth estimates for China & Russia sharply downwards as well. (Jan.28, 09) (Jan.28, 09) 2009 Rev. vs. Oct.08 projection

17. 17 All large countries in recession Bank of Japan now expects to contract (1/23/08) : Bank of Japan now expects to contract (1/23/08) : –By 1.8 % in year ending March 2008, –and by 2% in the coming year. Euro. Comm. : EU growth = -1.8% in 2009. (19 Jan.,09) Euro. Comm. : EU growth = -1.8% in 2009. (19 Jan.,09) China’s growth rate probably down by half. China’s growth rate probably down by half.

18. 18 Policy Responses Monetary easing unprecedented, appropriately. But it has largely run its course: Monetary easing unprecedented, appropriately. But it has largely run its course: –Policy interest rates ≈ 0. (graph)  The famous liquidity trip is not mythical after all. – As Krugman & others warned us in re Japan in 90s.  & lending, even inter-bank, builds in big spreads –since mid-2007, not just since September 2008. (graph) Now quantitative easing, as the Fed continues to purchase assets not previously dreamt of. Now quantitative easing, as the Fed continues to purchase assets not previously dreamt of.

19. 19 Policy rates have been cut most of the way to zero. US € Japan

20. 20 Bank spreads up when sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008). Source: OECD Economic Outlook (Nov. 2008).

21. 21 Corporate spreads between corporate & government benchmark bonds zoomed after Sept. 2008 US €

22. 22 Policy Responses, continued The TARP keeps evolving The TARP keeps evolving  First unspecific,  then to buy toxic loans,  then to recapitalize banks,  then auto bailout,  Now up in the air: –insure banks’ toxic assets rather than acquire them? –create “bad bank” as in “Swedish model”? –outright nationalization not yet under consideration in US.

23. 23 Policy Responses, continued Unprecedented US fiscal expansion, most of which is still to come. Unprecedented US fiscal expansion, most of which is still to come. –Obama proposed an $825 expansion –House passed a version. Senate will soon. –Good old-fashioned Keynesian stimulus  Even the belief that spending provides more stimulus than tax cuts has returned – not just from Larry Summers, for example, –but also from Martin Feldstein.

24. 24 Motivation for macroeconomic intervention The view that Keynes stood for big government is not really right. The view that Keynes stood for big government is not really right. –He wanted to save market microeconomics from central planning, which had allure in the 30s & 40s. Some on the Left today reacted to the crisis & Obama’s election by hoping for a new New Deal. Some on the Left today reacted to the crisis & Obama’s election by hoping for a new New Deal. –My view: faith in unfettered capitalist system has been shaken with respect to financial markets, true; but not with respect to the rest of the economy; –Obama’s economics will be centrist, not far left.

25. 25 International transmission As noted, international transmission remains powerful As noted, international transmission remains powerful –Despite floating exchange rates –Consistent with old-fashioned Keynes-Meade- Mundell-Fleming transmission via trade balances.

26. 26 Global Current Account Imbalances will probably now be forced to adjust US deficit will likely diminish, US deficit will likely diminish, –though adjustment requires $ depreciation. Who must take corresponding reduction in current account surpluses? Who must take corresponding reduction in current account surpluses? –Europe says: “Not us. Overall we are in balance.” –Others say: Europe can expect to take a share, roughly proportionate to its share in world trade, –IMF seems to think oil exporters will take all adjustment (see graph)

27. 27 Current account adjustment: US vis-á-vis oil exporters (as % of GWP; source: IMF)

28. 28 But the OECD sees the € - area bearing almost as much of the adjustment as non-OECD countries. Source: OECD Economic Outlook, Nov. 2008. 3/ as % of GDP

29. 29 Fiscal expansion internationally EU agreed 1.5% GDP expansion in Dec. EU agreed 1.5% GDP expansion in Dec. Most other countries as well Most other countries as well China: China: –the most obvious candidate for fiscal expansion. –Beijing announced RMB 4,000 billion ($585 b) in Dec.  It sounds big. Is it? –Fiscal expansion & development of health care, education, pensions, etc.: a more productive topic for discussion than RMB “manipulation”.

30. 30 International coordination of fiscal expansion? As in the classic Locomotive Theory Theory: in the Nash non-cooperative equilibrium each country fears expanding fiscally for fear of adverse trade deficit. Theory: in the Nash non-cooperative equilibrium each country fears expanding fiscally for fear of adverse trade deficit. –Solution: A bargain where all expand together. In practice: example of Bonn Summit, 1978 In practice: example of Bonn Summit, 1978 –didn’t turn out so well, –primarily because inflation turned out to be a bigger problem than realized (& German world was non-Keynesian). –That is less likely to be a problem this time.

31. 31 Emerging Markets

32. 32 3 cycles of net private capital flows to emerging markets, by region peaking in 1982, 1997 and 2008 Source: Capital Flows to Emerging Market Economies, IIF, Jan.27 2009.

33. 33 Capital flows to emerging markets peaked in 2007 from: EM Fund Flows, Citi, December 2008

34. 34 The Financial Crisis Hit Emerging Markets in Late 2008: Stock markets plunged and interest rate spreads rose Source: IMF WEO, Oct. 2008

35. 35 Among the “BRICs,” only China’s capital account has improved lately

36. 36 In mid-2008, foreign funds turned bullish on China and bearish on Russia Recession is hitting Russia hard. 1/3 of its reserves have been lost defending the rouble Recession has hit Russia particularly hard, due to falling oil prices. 1/3 of its reserves have been lost trying to defend the rouble.

37. 37 What characteristics help an emerging market economy resist financial contagion? High export/GDP ratio High export/GDP ratio High FX reserves and/or floating currency High FX reserves and/or floating currency Low foreign-currency-denominated debt Low foreign-currency-denominated debt Low short-term debt Low short-term debt High Foreign Direct Investment High Foreign Direct Investment Initially strong budget, allowing room to ease. Initially strong budget, allowing room to ease.

38. 38 The unsustainable US saving shortfall

39. 39 Downward trend in US trade deficit 1960-2006

40. 40 “Mainstream” View of Origins of US Current Account deficits Deficits affected by exchange rates & growth rates. Deficits affected by exchange rates & growth rates. –And indeed US TB has shown some improvement 2006-08, in response to $ depreciation & US growth slowdown. More fundamentally, the US CA deficit reflects shortfall in National Saving More fundamentally, the US CA deficit reflects shortfall in National Saving –US current account deficit widened rapidly in early 80s & 2001-05, associated with falls in National Saving.

41. 41 The US Current Account deficit originates in a National Saving shortfall, which in turn includes both a rise in the Budget Deficit & a fall in Household Saving.

42. 42 Net National Investment, Saving & Current Account, as shares of GDP

43. 43 Two global problems (US deficits & emerging market boom) came together in 2003-2007 The US balance of payments deficit financed by the People’s Bank of China, and other central banks & Sovereign Wealth Funds in Asian & oil-exporting countries. The US balance of payments deficit financed by the People’s Bank of China, and other central banks & Sovereign Wealth Funds in Asian & oil-exporting countries. Can this mutual co-dependency arrangement continue ? Can this mutual co-dependency arrangement continue ?

44. 44 Bretton Woods II: “China’s development strategy entails accumulating unlimited dollars.” Deutschebank view (Dooley, Folkerts-Landau, & Garber…): Deutschebank view (Dooley, Folkerts-Landau, & Garber…): Today’s system is a new Bretton Woods, with Asia playing role that Europe played in 1960s. Today’s system is a new Bretton Woods, with Asia playing role that Europe played in 1960s. That much is right. That much is right. DFL ideas were original: DFL ideas were original: –China piles up $ not because of myopic mercantilism, –but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance.

45. 45 But it is not sustainable. It may be a Bretton Woods system, but we are closer to 1971 (date of collapse) It may be a Bretton Woods system, but we are closer to 1971 (date of collapse) – than to 1944 (date of BW agreement) – or 1958 (when convertibility was first restored).

46. 46 US politicians focus on the bilateral trade deficit, despite its lack of economic importance. US politicians focus on the bilateral trade deficit, despite its lack of economic importance.

47. 47 If China gave US politicians what they say they want... We might regret it. We might regret it. –especially if it included reserve shift to match switch in basket weights away from $. US TB & employment wouldn’t rise US TB & employment wouldn’t rise –fall in US bilateral trade deficit with China would be offset by rise in US bilateral deficit with other cheap-labor countries, but US interest rates probably would rise. but US interest rates probably would rise. –possible hard landing for the $.

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49. 49 The RMB I agree with a majority of economists that I agree with a majority of economists that –RMB appreciation is in everyone’s interest. –The movement vs. the $ since 2005 does not constitute sufficient flexibility. But on the other hand, But on the other hand, –I do not agree that China’s $-link should be labeled “manipulation in violation of international agreements”; and –Higher priority should be placed on expansion of domestic demand, and structural shift from manufacturing to services, especially health, education, pensions.

50. 50 A global cooperative deal A global cooperative deal would simultaneously appreciate the RMB & other currencies of Asians & oil-exporters, while the US raised national saving. A global cooperative deal would simultaneously appreciate the RMB & other currencies of Asians & oil-exporters, while the US raised national saving. IMF could broker the deal. IMF could broker the deal. China & US will not be dictated to. China & US will not be dictated to. But in a $ crisis -- if US stands to lose the best customer for its T bills, and China stands to lose the best customer for its goods – both may see the advantages of a deal. But in a $ crisis -- if US stands to lose the best customer for its T bills, and China stands to lose the best customer for its goods – both may see the advantages of a deal. China would admit that it has not already fixed its currency, and that domestic demand also needs to be increased. US would admit that it has a budget deficit problem, and that the trade deficit is not China’s fault. China would admit that it has not already fixed its currency, and that domestic demand also needs to be increased. US would admit that it has a budget deficit problem, and that the trade deficit is not China’s fault.

51. 51 The US & $ have had special roles in global monetary system for more than 60 years. “Exorbitant privilege” of funding US current account (or basic balance) deficits by borrowing in dollars “Exorbitant privilege” of funding US current account (or basic balance) deficits by borrowing in dollars As a safe haven, US has benefited from flight to quality As a safe haven, US has benefited from flight to quality Dollar as number one international currency Dollar as number one international currency –#1 reserve currency in central bank holdings –other functions: invoicing trade & financial flows, etc. But the euro is now a credible rival But the euro is now a credible rival –Chinn & Frankel (2007, 2008) –The dollar’s special role could come to an end.

52. 52 Chinn & Frankel (2008) simulation Figure 7: Only accession countries join EMU in 2010, (UK stays out) but 20% of London turnover counts toward Euro area financial depth, and currencies depreciate at the 20-year rates experienced up to 2007. € passes $ around 2015

53. 53 The 2007-08 financial crisis has probably further undermined the US position in the long run US financial institutions have lost credibility US financial institutions have lost credibility Expansionary fiscal and monetary policy may show up as $ depreciation in the long run. Expansionary fiscal and monetary policy may show up as $ depreciation in the long run. The long slow decline of the $ as an international reserve currency may accelerate. The long slow decline of the $ as an international reserve currency may accelerate.

54. 54 In the short run, however, the financial crisis has caused a flight to quality which apparently still means a flight to US$. US Treasury bills are more in demand than every, as reflected in very low interest rates. US Treasury bills are more in demand than every, as reflected in very low interest rates. The $ appreciated in 2008, rather than depreciating as the “hard landing” scenario had predicted. The $ appreciated in 2008, rather than depreciating as the “hard landing” scenario had predicted. => The day of reckoning has not yet arrived. => The day of reckoning has not yet arrived.

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