October 21, 2008 6:50 pm

The world wakes from the wish-dream of decoupling

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Ingram Pinn

The US retains the capacity to disrupt the world economy which it has possessed since at least the 1920s. Accordingly, the struggle between the deleveraging of high-income countries and the growth momentum of emerging economies is ending, alas, in a decisive victory for the former.

Yet the news is not all bad: inflationary pressures are abating fast. Even so, this hides more bad news. The broken financial system will weaken the transmission from monetary easing to the economy. This will make the coming slowdown last a long time. Even though decisive action has saved the financial system from its recent heart attack, the patient remains enfeebled.

In 2007, the world economy (measured at market exchange rates) grew by 3.7 per cent in real terms. This year, according to the latest World Economic Outlook from the International Monetary Fund, growth is forecast to be 2.7 per cent. Next year it is expected to be a mere 1.9 per cent. The economies of high-income countries are forecast to stagnate next year. Meanwhile, emerging economies are forecast to grow at 6.1 per cent. This seems fast. But it is 0.6 percentage points slower than was forecast in July and is well below the 8 per cent achieved in 2007 and 6.9 per cent still forecast for 2008.

The pleasant surprise is the forecast growth of 6 per cent in Africa next year. Developing Asia is forecast to remain the world’s leader, with growth of 7.7 per cent: China is on 9.3 per cent, while India is down to 6.9 per cent. Meanwhile, central and eastern Europe is forecast to grow only 3.4 per cent next year and the western hemisphere to grow even more slowly, at 3.2 per cent.

These forecasts were prepared before the worst of the financial shocks of September and October. As Mervyn King, governor of the Bank of England, remarked in a speech delivered on Monday night: “Radical action was needed to ensure the survival of the banking system.”* Indeed, the very fact that governments felt obliged to pump so much new capital into their financial systems indicates how serious the crisis was.

Recent US data on retail sales, housing starts, industrial production and consumer confidence suggest the economy is tumbling into recession. The plight of several other advanced countries is similar, not least the UK.

Consider the burdens weighing down on these countries. Between 1980 and 2007, the ratio of US gross financial debt to gross domestic product – a measure of the sector’s leverage – jumped from 21 per cent to 116 per cent. Today, as a result, the arteries are clogged with bad debt.

Moreover, while the US government (and those of other western countries) are committed to saving the core banking system, the non-bank financial system, including the hedge-fund sector, looks set to implode as financing dries up, with inevitable forced sales of financial assets and further insolvencies.

This is the reality behind the euphemism, “deleveraging”. This occurs via mass bankruptcy, unless bad private debt is shifted on to the public sector’s balance sheet. “Debt destruction” is a better name. In the US and elsewhere, asset prices, particularly of housing, also continue to fall. Who is going to borrow to purchase such assets? What lender would use such assets as collateral, unless they are protected by generous equity cushions? The credit mechanism is broken. This must be so when spreads on riskier credits are shooting up (see charts). If banks cannot borrow easily, few can.

It should be remembered, in addition, that US households have been spending an exceptionally high share of incomes in recent years and running exceptionally large financial deficits. This, too, will change, as credit-starved households cut back on spending and those who have suffered large losses increase their savings.

In short, the worst consequences of the recent banking crisis – a depression – have been avoided. But the impact of the implosion of what the hyper-bearish Nouriel Roubini, of RGE Monitor, calls “the largest leveraged asset bubble and credit bubble in history” is hitting real economies increasingly hard.**

It is an ill wind that blows nobody any good: the IMF is back in business, already helping Iceland, Pakistan and Ukraine. The list of countries in trouble also includes Bulgaria, Estonia, Latvia and Turkey. While China and India look reasonably crisis-proof, even they will be adversely affected. Investment and net exports generated close to three-quarters of China’s incremental demand in recent years. Both will be slowed by this crisis – net exports directly and investment indirectly. While China’s government has the resources to offset weakening demand, through fiscal action, it is likely to do too little too late.

The emerging economies will not decouple. This is not surprising: the US and European Union generate 54 per cent of world output, at market prices. With Japan, they generate 62 per cent. A sharp slowdown in these countries is bound to have a big impact on the rest of the world. But some of the emerging economies should still be able to sustain reasonably rapid growth.

The slowdown and financial distress has lowered commodity prices, though to a still relatively high level (see chart). The IMF already forecasts consumer price inflation at 2 per cent next year in high income countries. This decline is bad for commodity exporters. But it will promote needed reductions in official interest rates. While the impact of lower rates will be modest, they will still help.

Yet, in current conditions, monetary policy will be insufficient. This is a Keynesian situation that requires Keynesian remedies. Budget deficits will end up at levels previously considered unimaginable. So be it.

Two further measures must be implemented. The first is enhanced procedures for restructuring debts of bankrupt households. The second is provision of sufficient funds for low-conditionality IMF rescues of developing economies. Today, the IMF is exceptionally liquid. But that may well not remain the case for very long, as conditions get still worse.

The challenge was – and remains – to ensure that what might have been a true economic depression ends up as a shallow recession in the most affected high-income countries and a modest slowdown in emerging ones. Enough has now been done to prevent a meltdown of the financial systems of several advanced countries. More must be done, if necessary. But a long and deep global slowdown is still likely. Determined action is needed to limit these effects. That remains the immediate challenge for policy.

US corporate bond spreads

*www.bankofengland.co.uk; **October 17 2008, www.rgemonitor.com

martin.wolf@ft.com

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