It’s not a pretty picture right now. The short and medium outlook looks pretty tough. The advanced economies are out of money, out of growth, out of balance and out of trust. That is probably the principal challenge that we face in the global economy.
This looks to me like a perfect storm, with the following components.
- A massive failure in the area of counter-cyclicality in both private and public sectors with varying weights across countries (and with some notable exceptions)
- Very substantial demographic headwinds pushing against fiscal re-balancing and growth, with embedded inter-generational fairness and equity issues
- An involuntary build-up of debt and other liabilities as a result of the shock of the crisis.
- Countries running on what I call Defective Self-Limiting Growth Models. That is, ones that have built-in decelerators and just can’t keep functioning.
And the particular version of it – there’s quite a long library if you study developing and advanced countries – which we seem to have invented in varying combinations is: excess private and government consumption, enabled by leveraged asset inflation and complementary global imbalances; combined with deficient investment and structural imbalances, caused by the distorted composition of aggregate demand.
And now the challenge is a dual one. It’s to adopt a sensible balanced intertemporal approach to the twin agendas of deleveraging and restoring growth in a more sustainable pattern. It’s hard to do that because there is a double burden: we have to pay for past excesses and we have to invest in assets that generate future growth and employment momentum. And somebody has to pay for that.
Right now, there are political and policy non-responses, lack of force and decisiveness in policy responses. I believe this is, in part, because it’s hard to generate the political will to do that when you’re wrestling with this very difficult problem of deciding how to fairly share the burden. And since we are not making progress on that front, the burden at the moment is being disproportionately shared by – or disproportionately landing on – the unemployed, with special emphasis on the young. That, in turn adversely affects social cohesion – which, in my mind, is a kind of social capital – and makes it more difficult to generate and sustain and formulate pragmatic political policies and consensus. Somehow, we are going to have to break through this because the whole global economy – and not just these countries – depends on it.
This is a world of extraordinarily large global macro risk. You can see it in the elevated correlations across financial markets. It’s a sure indicator of systemic risk. And, at bottom, much of this risk when you really think about it, is not associated with resources or competence, it’s associated with political will. It’s associated with uncertainty about policy responses and circuit breakers that, in principle, are capable of stopping various kinds of financial and economic distress, but we don’t know if they’re going to be effectively deployed or not.
Europe is the epicentre of this global macro risk. Greece may or may not exit. That’s what friends of mine call “the known unknown”. It’s not the main event in Europe. In my view, and in the view of a number of other people, Greece has very little growth potential inside the eurozone without a terms-of-trade re-set. Other people argue against that and say that the tradable side of the economy is all tourism and it doesn’t matter. Or that they’ll mishandle it in macro terms if they do it. We can set that aside. There is some contagion risk. Everybody in this room who experienced 1997-98 in Asia – spilling over to Latin America – knows that it is there, even if investors can distinguish clearly between Greece and Portugal, on the one hand, and Italy and Spain on the other. Nevertheless they may be afraid that everybody else will exit and that this thing could get out of hand. The ECB and the eurozone core have the tools to limit that and so you can place your own bet on whether they’ll use them. I believe they will.
The main event is the reform processes in Italy and Spain. These are the third- and fourth-largest countries in Europe, and Italy is the third-largest sovereign debt market in the world. These reforms are crucial, they’re crucial to stabilise these countries – though they will take time to implement – but they’re also crucial because support from the eurozone core will not be forthcoming in the absence of reform in these countries. And that’s the other crucial piece of the puzzle.
So this all fits together; you know what has to come in place. In my view – and some of you don’t know this, but I live in Italy so I have a kind of front-seat view – I would say we’re making progress. [Prime Minister] Mario Monti is a very talented guy. He’s determined to get this done. He’s not a career politician so he doesn’t worry about the fact he may not have a political future when he gets this done. The political parties may decide that’s a good thing and let him do it, because it’s better than having yourself do it, destroying your political future. But it’s not a done deal.
In my view, the big danger zone right now is Spain. Spain is systemically important and it is in financial, economic and political difficulty. The unemployment rate is 25 per cent. The youth unemployment rate is close to 50 per cent. The social cohesion and political resolve are starting to erode, the yields are back up over 6.5 per cent – and rising – and, thus far, there’s been no recent intervention in that area, and growth is negative.
It’s very easy to see in this context that this is an environment in which the incentives and persistence with respect to playing this game may shift. This is, in fact, what I call a two-scenario world. Or, in another context what Mohamed El-Erian and I have characterised as a situation that has “multiple equilibrium structures” – these are configurations in which expectations shifts, when they occur, cause self-fulfilling responses in terms of incentives and market and political outcomes. So you can actually get two stable different outcomes and it’s pretty easy to see what they are. In the European context, one of them is we slowly climb out of this hole we’re in; the other is that we give up on the game. And they’re both equilibrium.
Distributions, from an investment point of view, are bi-modal reflecting these two scenarios. It’s a very difficult investment environment and right now many investors have decided the best way to deal with it is just to sit on the sidelines.
On the US side of the Atlantic we have a delayed but growing recognition of structural and re-balancing challenges in addition to the deleveraging process. Employment is not recovering. There’s a clear pattern of divergence between growth and employment – the result of the operation of very powerful technological and global economic forces – and, thus far, this set of problems associated with the operation of these powerful forces, including unemployment and very big difficulties with income distribution, have not been countered in any effective way by government investment or policy responses.
The income distribution is deteriorating on a continuing long-term trend and, combined with high middle class and youth unemployment, social cohesion – or what in America is called the social contract – is starting to become shaky. In addition, politics is gridlocked. The hope is, that will change when the election comes along.
There is some good news. People who believe in markets have something on their side. Our economy is starting to adjust. Paul Volcker told me that what I’m about to say is like planting a seed of grass and seeing the first little shoot arrive. I think that’s a fair characterisation of this. Manufacturing is actually growing, manufacturing exports are growing, exports are growing faster than imports and the current account deficit is coming down. We are starting to access more external demand since our domestic aggregate demand collapsed, post-crisis, and it’s even possible that the government and business are starting to shift their attitudes in the direction of treating labour – skilled labour, particularly – as an important intangible asset and, like Germany, adopting policies and procedures at the corporate and the national level that reflect that kind of belief.
There is, finally, on the American side, immediate political risk. The extended unemployment benefits will expire relatively soon and then we have the period between the election of the President and the swearing in of the President. It’s about two-and-a- half months and is called the “lame duck” period. In that period the debt ceiling issue will come up again. We will hit the debt ceiling. This presents an opportunity for another fiasco. The Bush tax cuts will expire and the payroll tax holiday will expire. So, if the government does nothing in that period, there will be a huge tax increase – involuntarily, in some sense. If the new Administration and Congress are gridlocked, markets which have been pretty gentle with the American sovereign debt market may, I think, turn. At least there is some risk of that.
Emerging economies are, relatively speaking and absolutely, the bright spot. Public debt to GDP ratios in the developing countries – across the board – are trending down to 40 per cent of GDP. In the advanced countries they’re trending up to 100 per cent of GDP, with lots of them over 100 per cent.
The late Nineties were a pretty painful experience in Asia but there was a ton of very useful learning that went on that is now reflected in this differential configurations in the advanced and developing countries. And there is partial decoupling. The recovery in the major emerging economies – and that helped the rest of the developing world – was really quite impressive. An extraordinary degree of resilience was displayed, and reduced dependence. This is a function of the supply chains and the evolving network structure of the global economy. But I do caution this is still partially decoupling. In fact, we’re still all linked. If the downside scenario in Europe should come to pass, it will materially adversely affect the rate of recovery in the United States and it will also adversely affect the emerging economies. So the message that I hope we deliver, among other things, from the Asian side, is that at some very deep level, our interests are completely aligned. There is nothing better for the Asian countries than a stablisation and then recovery in Europe, and a fairly rapid recovery in the United States. It’s by far the best outcome with respect to multiple agendas.
There is some loss of growth momentum in the emerging economies, including China and India, and that’s not surprising. I used to calibrate resilience and decoupling as: if we go flat on the Western side, the growth can keep up. But we’re not flat any more, we’re heading downward. And that’s got to take away enough aggregate demand in the global economy to produce a problem.
China is very important right now. It’s just under half the size of the EU, or the US. That means that 8 per cent growth in China is the approximate equivalent of 4 per cent growth in Europe or America and that never happens on a sustained basis, so you can see easily why this is so important.
There are lots of challenges, but there’s lots of leadership and talent and competence to deal with it. In my mind, in China there has been a highly successful export- and investment-driven growth model that could become a defective growth model without fairly elaborate system and institutional changes that do a lot of things, but one of them is eliminate the potential and the reality of low-return investment, and would increase the marketisation in the economy. This is well understood and I think the key is implementation, reform momentum, resolving divergent interests and completion of a successful leadership change.
My view on this is there’s good reason to be optimistic. The track record of managing complex transitions is very good. On the other hand, this is the middle-income transition and the normal case is you stop or slow down badly, even if you enter at high speed. And the high-speed transitions in the middle income are the exceptions, not the norm. This is not the place to list them all and discuss their cases. So, statistically, this is not a cakewalk by any means. And it’s never been tried at the scale that it’s being tried at in China right now.
India is a little bit behind in terms of growth acceleration but is the other future economic giant. There has been some loss of reform momentum in the past year and a little bit of an adverse shift in investor confidence. My view is that this is a temporary setback. There are deep assets, of the type that were described in the United States context a few minutes ago, embedded in the Indian economy in lots of different sectors. And there’s lots of talent to deal with this. In my view, China’s structural evolution and movement up the value-added chain in terms of industrial structure, and as incomes rise, presents rather substantial opportunities for India and other developing countries in terms of expanding the growth and employment engines for the less-skilled parts of their population.
Finally, India’s public sector balance sheet is not as large as China’s in relationship to the size of the economy, so has less ammunition to deal with shocks than China does. So I think restoring the reform momentum is a little more urgent than it might otherwise be if that balance sheet was bigger.
Standing back from all this it seems to me that the challenges essentially come down to various aspects or dimensions of what I think of as “sustainability”. And what are these dimensions? Everybody has their own list but I’ll give you mine.
1. We need stability. We need debt dynamics and public finances that make sense; we do not need an unregulated huge shadow banking system; we do need bank capitalisation; we do need, over time, to address an increasingly creaky international monetary system in which everybody gets to choose their exchange rate and capital account regime. That just doesn’t make any sense; there’s externalities, that’s a non-cooperative equilibrium in a place where there’s clear external effects. It just doesn’t hang together.
2. The second dimension is equity – inclusiveness and social cohesion. For me social cohesion is an intangible asset. So, running it down is no different than running down the natural resource base of an economy. It just does damage in a different part of a very large balance sheet. And the reason it’s important is that, if you run it down enough, the political system doesn’t work. It starts to become polarised and turn in on itself. It develops auto-immune characteristics that are not very helpful.
3. The third dimension is structural balance and avoidance of what I call these defective, unsustainable growth patterns.
4. The fourth is global coordination and cooperation. I just mentioned one dimension – trade came up here clearly. There are lots of areas in which the non-cooperative equilibrium is sub-optimal – meaning an inferior outcome for everybody – and, right now, it’s not a good time to build global institutions, except when we’re in a crisis and the responses seem to be pretty good. But we’ve got to get on with it at some point and Asia has to play a very important role because of its growing size and the fact that it’s just plain healthier than the rest.
5. The final and probably the most important dimension is what I call long-term scalability. And this is what most people think of when they think of the question of sustainability. I believe convergence will continue, albeit in a bumpy fashion, by virtue of the rapid growth of the developing countries. Far from being a zero-sum game, this is the engine that will drive a global economy from its current size to three times its size in the next 20 to 30 years. It’s a set of forces that will take the post-War 15 per cent of the global population that lived in style in advanced countries – whatever style meant – and take that number to 85 or 90 per cent. I mean it’s a complete sea change. And I think there’s a growing awareness that if we try to accomplish that global transformation using the old growth model, it’ll fail. The natural resource base of the planet is just not up to that. It flunks the most basic test that we use in economics when we do general equilibrium theory, which is the “adding-up” test. You can’t take what’s good for one or few, apply it to many and not ask “does the system still work?” And somebody described it, in one of the materials that was distributed, that the UN estimated that if all this growth actually occurs, we’ll need something like two or two-and-a-half planets of approximately the natural resource base that we have, rather than one. Obviously, climate change is an important aspect of this, but it has multiple dimensions. And that’s why the Fung Global Institute has put sustainability under these multiple dimensions as an important – maybe not the most urgent – long-run agenda.
Let me finally say, if you look at the balance sheets of public sector in the advanced countries, you see two things. You see very high levels of public debt and you see astronomical levels of non-debt liabilities. When you look at those liabilities, they have the following characteristics. They look terrifying, but they’re longer term and if you change the dials on the programmes – the pension parameters and stuff like that – then you can reduce those liabilities substantially. That sounds like the good news but the bad news is you don’t have to act now and so you tend to delay until you’re in real trouble and that’s the pattern we’ve been doing. We could do the same thing in the natural resource area, in the sustainability area. I mean Nick [Lord Stern] has been the leader in telling us this is urgent, now. But I think what we’re really saying is, this is a long journey we have to take. We’re going to have to invent this new growth model as we go along. And it’s far better to get started on it now, rather than say “Well, no, we’re busy. We gotta kind of fix other things and then we’ll get to it.” So, we’re hoping that the Fung Global Institute can play a role in engaging a wide range of people – but including, especially, business – in that longer-term process.
With that, I will stop and say thank you for listening.