Growing pains

A typical European childhood is marked by regular torture sessions at the hands of this most overrated of French writers: Saint-Exupéry. His “Little Prince” is so overwhelmingly praised above its squalid merits that any resistance becomes futile. One just has to go through it.

And yet, there is some material that, properly edited, can be salvaged from the book. Here I give a try to the parable of the baobabs. Probably anybody here will remember it: a regular asteroid inhabitant has to keep it’s planet clean of “bad weeds” (pun intended), lest them grow wild and eat up the whole asteroid, the baobabs standing for vices of character, the asteroid for one’s own person, yadda, yadda, snore, snore…

This is a different metaphor (disclaimer – albeit probably equally boring) It strikes me as incoherent that, for a world economy that is, in its most part, growing at a very decent pace, there’s such a desperate focus of policies in achieving growth.

We hear all over that recovery is uncertain, that there are still risks ahead (when where there not, pray?), that more needs to be done to get out of recession.

A cursory look at the main economies growth rates, though, makes one think they are talking about a different asteroid. Here is a list of estimated GDP growth rates for 2010 (corrected for China with the official digit), probably very close to what definitive figures will be:

  • US   2,8%
  • China   9,8%
  • Japan   3,4 %
  • Germany   3,5%
  • India   8,3%
  • Brazil      7,5%
  • Korea   5,8%

Are these the growth rates that define a recession? Probably when we talk about recession, we are referring to unemployment and, to a lesser extent, debt and financial instability. These are unemployment rates for major economies:

  • Euro area 10,1% (varying from 20% in Spain to 4,4% in the Netherlands)
  • US 9,4%
  • Canada   7,9%
  • Japan   5,1%

So there it is. The economy is in fact growing at very handsome rates pretty much all over, but no employment is created. That’s what the word recession means these days. And now for the interesting part: Why?

I can only think of it as a result of the policy mix used to fight the banking crisis of 2008. The better part of so-called fiscal stimulus packages has been devoted pretty much all over the world to more or less indirect rescue operations of the financial sector. When fiscal stimulus programs (as opposed to financial rescues and monetary stimulus) have been implemented, they have tended to be based on tax cuts (which, as we know, increase private consumption to a much lesser degree than direct public expenditure)

The monetary approach has been much more vigorous and, together with bank rescues performed through the balance sheet of central banks (i.e. monetary expansion) have increased liquidity enormously.

Banks that would otherwise have gone bankrupt have been propped up with central bank credit and/or taxes money. But the economic activity has not recovered to the level of activity previous to the crisis, resulting in an excess financing capacity relative to economic activity, even after taking account of the increased funding needs of governments, which absorb part of this excess liquidity. After all, the main instrument of bank rescue has so far been monetization.

As a result, hot money has accumulated in the hands of investors, both financial and industrial. Investment in capacity and stock has been building up, just in the same way as the price of raw materials climbed in the last year. To wit, consumption has been timidly recovering but it seems that so far investment is the main driver of the pick-up in demand.

There is a pattern that starts to become apparent in the main economies of the world, consisting in excessive growth relative to their consumer markets. This is achieved through investment in productive assets, which makes for greater productivity, and higher potential output. This pattern of growth changes the factor utilization rate, so that the same output is achieved with a smaller work force.

This is a lower quality growth, as long as the purpose of economic activity is improvement of the quality of life and full use of the productive factors. Labour is not fully employed and insufficient private consumption demand is thus created. More worryingly, expanding production to full employment level would imply an output level much higher than what consumers can demand, since the capital level is so high. The sole solution becomes export of excess production. When every major economy in the world plays this game, it is difficult to see where exports go.

Nowhere is this more apparent than in China , with an economy so inefficient and capital intensive that 8% annual growth is required to maintain unemployment even. This can only be achieved through exports, hence the deliberate undervaluation of the Yuan.

Germany has traditionally been a similar case, with a savings rate higher than 10% limiting internal demand and a trade surplus of more than 10% its GDP (here’s an interesting fearful symmetry to frame…)

The US has been building capacity during 2010 beyond what internal consumption would have granted. The main drivers of internal demand have been inventories and investment. Perspectives are brightening but the consumer has yet to follow suit in earnest. This failing, the US will also be in a situation where excess capacity forces prices down and external markets need to be found.

“Luckily” there’s a limiting factor that will avoid the situation: much before that, the baobabs will have eaten up the asteroid. Or threatened to do so, which can amount to the same. With limited resources and considerable excess capacity, actually producing at the potential world output level would be physically impossible. With the kind of liquidity that now swamps the markets, investors try to anticipate the surge in demand that closing the output gap will bring and create an immediate rise of commodities prices. The earth is, after all, the only closed economy we know, and excess liquidity will sooner or later surface as higher prices.

Paradoxically, the only way that I see to avoid this would be to actually prop up demand through truly Keynesian policies, that would need to substitute the monetary-only approach followed until now. Alleviating monetary policy of the heavy responsibilities it now shoulders, for which it is ill prepared (stabilizing the financial system, maintaining price stability AND achieving full employment) would recoup some of the exuberance in commodities prices and allow recovery of consumption and economic activity.

Alternatively, we can roll another collective joint and agree that more needs to be done to grow the trees a further 10% so unemployment falls maybe 2%. By the time the last unemployed gets his job there will be no planet left.

(I was fearing this: I ended up sounding exasperatingly Saint-Exupérian… Serves me well, for trying to salvage this hopeless wreck of a book! At least I hope this image of the Little Prince “aux fines herbes” can help you replace his annoyingly righteous image in your memory…)

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About Outis

Nobody is cooler than you
This entry was posted in Fiscal policy, Growth, Monetary policy. Bookmark the permalink.

One Response to Growing pains

  1. Outis says:

    A discerning reader makes an interesting, if difficult question: If this is the situation (and he doesn’t necessarily agrees it is), what’s to be done? May sound egregious of mine to try to straight up from here the state of the whole world but since I’m asked (and nobody else seems to be at it), here goes a list of tasks for each actor involved:

    – China: appreciate the Yuan. This will improve the living conditions of its masses, reduce capital formation and external surplus, lower internal inflation and, generally speaking, balance better in time wealth accumulation vs. its use.
    – Germany: just rescue them buggers and assume that when you enjoy the benefits of a single currency you are bound by some liabilities too. Germans like to always win but in real life this is an elusive goal. Some wealth transfer will justify an Euro at the exchange rate it trades today (which is inconsistent with present fiscal tightening in Europe and Germany’s trade surplus), and thus allow Germany to keep on thriving while helping its poor neighbours carve out a living for themselves. China’s Yuan appreciation would certainly help with this.
    – Japan: really beats me. I would say some debt/assets consolidation would give a more realistic view of its finances to the markets. Beyond that, some appreciation of the currency and development of internal demand would be nice but how to achieve it…
    – US: depreciation of the dollar vs. Yuan would be a start. Beyond that, well targeted fiscal policy has to be substituted with QE2. Examples:
    Wrong policies: tax cuts, esp. for higher rents, military expenditure, financial rescues without managerial control
    Right policies: unemployment and poverty alleviation (subsidies), medicare, infrastructure projects liable to improve productivity, etc.

    As to how these policies would be funded, a mix of expenditure substitution from programs not increasing demand, higher deficit and lower monetary expansion might be some way to muddle through.

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