The great financial bubble of the Clinton-Bush years has ended in tears–in home foreclosures, bank failures and what promises to be the most severe global economic recession since the Great Depression. As President-elect Obama puts together his economic recovery program, he needs to understand that the economic crisis is the result not just of unscrupulous mortgage lenders and unregulated investment bankers on Wall Street but of the globalization of finance and trade that key members of his economic team set in motion when they were in the Clinton administration. The uncomfortable truth is that the current system of global commerce and transnational finance is inherently prone to crisis and is incompatible with Obama’s goal of rebuilding the American middle class. Any sustainable recovery on the domestic front, therefore, will depend on his success in getting other countries to agree to fundamental changes in that global system.
Globalization is not necessarily bad if properly regulated among similar economies. But the globalization of the Clinton-Bush era not only lacked safeguards for labor but rested on two mutually reinforcing, flawed models of growth: debt-financed consumption in the United States and other Anglo-Saxon economies and oversaving and underconsumption in the production-oriented export economies of Asia. Not surprisingly, the global integration of these radically different economies produced an unhealthy pattern of growth characterized by asset bubbles and large global trade imbalances, with the United States running large deficits and China and Japan running large surpluses.
The root cause of this unbalanced world economy was the enormous pool of excess savings generated by China, Japan and, more recently, the petrodollar states of the Persian Gulf. This global savings glut, as Federal Reserve chair Ben Bernanke called it, helped fuel a succession of asset bubbles in the United States, culminating in the expansion of easy credit and the rapid run-up of housing prices following the collapse of the tech-stock bubble. The housing and credit bubble in turn helped inflate consumption by enabling households to take on more debt; household debt as a percentage of disposable income rose from 90 percent in the late 1990s to 133 percent in 2007.
This pattern of economic growth had other worrying features. Corporate profits soared as companies in the developed world took advantage of China’s low wages, lax environmental standards and undervalued currency to locate production there. But wages and family income in the United States stagnated under this and other low-wage competition (as well as from the declining power of organized labor). As a result, income and wealth inequality increased in the United States and China. The US tradable-goods sector also took a hit as Japan, China and other Asian economies manipulated their currencies to maintain competitive advantage. Over the past seven years the United States lost nearly 4 million manufacturing jobs. During this same period, large chunks of industrial capacity were transferred from more energy-efficient developed countries to energy-inefficient developing countries like China, which compensated for its energy inefficiency with lower wages. This relocation of production helped spur increased demand for oil and gas, setting off an energy price spiral, which was exacerbated by bubblelike speculation in these commodities. Higher oil prices resulted in the transfer of huge amounts of wealth from middle- and working-class people in the United States and other oil-importing countries to oil producers in the Gulf and elsewhere.
This pattern of economic growth was not sustainable because it caused a huge shortfall in global demand, which had to be filled by America’s debt-financed consumption–the US current-account (all the goods and services imported balanced against those exported) deficit increased from 1.7 percent of GDP in 1997 to 6.5 percent a decade later. Economic growth came to a crashing halt when US households reached the point where they could no longer take on more debt. The bursting of the housing and credit bubble set off a deleveraging process that has spread across the world economy. In fact, few countries have been immune to falling asset prices and frozen credit markets, or to rapidly falling demand for their goods and services.
Because the incoming Obama administration faces a crisis of global proportions, a recovery program will have to be global in scope, and it will have to correct the huge imbalances globalization created. The president-elect has said very little about his international economic policy. But if he wants to see a sustained recovery, he will have to put forth an international economic reform program that is as bold as his proposed domestic program. The reason is simple: given the high levels of household debt, the US economy can no longer be the demand locomotive that pulls the rest of the world out of recession. Other economies will have to pull alongside the US economy.
The main focus of the new administration’s international economic statecraft must be on the large current-account surplus economies–China, Japan, Germany and the petrodollar states, which are running surpluses of 9.5 percent, 4 percent, 7.3 percent and more than 10 percent, respectively. These economies must lead in spurring world growth not only because, with the United States, they bear responsibility for the crisis but also because they are in the best position to lead, given their large surpluses and foreign currency. For better or worse, they must become the collective substitute for the American locomotive, either by stimulating demand in their own economies or by recycling their surpluses to stimulate demand in other economies.
The first element of the new administration’s global program should be to encourage China and other large surplus economies to expand domestic demand to offset weakened US consumption. Germany, Japan and the Gulf states are well positioned to expand their economies–preferably by cutting taxes on consumption and increasing social spending to spur more domestic consumption. China has announced what at first appeared to be an impressive stimulus program of $586 billion over two years. But it turned out to be mostly a repackaging of existing spending commitments by local governments and state companies and was heavily weighted toward infrastructure investment, which in the case of China will do little to create domestic consumer demand. Worse, the central government took steps to shore up the export economy by increasing export subsidies and allowing the yuan to depreciate, thus making Chinese goods less expensive in the world market.
In shoring up its export as well as its state-led investment sectors, China has embraced what amounts to a beggar-thy-neighbor strategy that supports its growth by taking a larger share of a shrinking global pie. And that is what global depressions are made of. A change in the pattern of China’s growth is not only critical but long overdue. Over the past decade, investment and savings there have grown much faster than consumption. Consequently, China has an unusually high savings rate of nearly 50 percent, while consumption constitutes only 35 percent of the economy. A world economy simply cannot function when the second-largest economy (measured by purchasing-power parity) has such a lopsided imbalance between savings and consumption.
The Obama administration therefore needs to signal to Beijing that it is unacceptable for China to run such large surpluses and that it urgently needs to do more to generate consumer demand. The new administration must make clear that if Beijing does not do more to support a global recovery, Washington will be forced to radically reshape its trading relationship with China when the crisis is over.
The first appeal to China, however, should be to its own interests as well as to its expressed desire to be a responsible stakeholder in the global economy. Indeed, the overarching message of Obama’s international statecraft should be strikingly positive: the United States is not demanding austerity and painful budget cuts, as the Clinton administration did of so many East Asian countries after the 1997-98 crisis. It is asking China to raise the living standards of its workers, spend more on their healthcare and education, and provide a decent pension for older citizens. These things should endear China’s leaders to their people and lessen the risk of internal social conflict.
China’s leadership, of course, is concerned with creating enough jobs to maintain political stability. Some leaders are reluctant to move away from the strategy of job creation, which has worked over the past decade. Therefore the Obama administration should argue that domestic-generated demand is a more reliable way for China to ensure political stability and job growth than building more factories and financing more exports to a stagnating US and European consumer market.
Obama also needs to make it clear that the reason the United States is pressing China and other Asian economies to raise wages and improve living standards is not so it can reclaim jobs lost to China but to increase global demand so all economies can create more jobs. Higher wages in China and other high-savings Asian economies would increase the purchasing power of Asian workers and augment consumer demand. The US economy would indirectly benefit from those higher wages and living standards because it would increase the demand for US goods and services, especially for labor-saving and efficiency-enhancing technology.
The quickest way for China to raise its living standards is by increasing the value of the yuan against the dollar and other international currencies. A stronger yuan would stem future inflation while reducing the cost of food, energy and other imports for Chinese consumers. Appreciating the value of the yuan would be a first step in a broader realignment of world currencies to help correct global trade imbalances. The best short-run option would be for the surplus economies of Asia to re-peg their currencies by letting them appreciate against the dollar but without abandoning the managed peg. This would set the stage for an important institutional change in the global financial architecture whereby the burden would shift to surplus economies to adjust their currencies and stimulate domestic demand, as Keynes originally envisioned.
Some of the surplus economies will not be able to stimulate consumer demand sufficiently in the short term to reduce their surpluses to acceptable levels. That leaves the alternative–recycle some of those surpluses to stimulate growth and economic development in other countries. The United States, of course, will need access to some of these surpluses to help fund its recovery program, but other surpluses could be redirected to support what should be a second pillar of the new administration’s world economic recovery plan–namely, establishing a world economic recovery fund to deal with balance-of-payments crises and to support public works projects in developing economies.
A number of countries–Iceland, Hungary, Pakistan and Ukraine–have suffered serious debt and liquidity problems related to the crisis and have sought money from the International Monetary Fund and other sources. These countries may need more money in the months ahead, while countries in Eastern Europe, Africa, Asia and Latin America may also experience currency-related crises before the world economy is stabilized. The IMF, however, has only $250 billion for managing national debt crises–a mere pittance compared with the rescue plans that the United States, Britain and other G-20 governments have embarked on or those that are needed to deal with the approaching crises in Turkey, the Baltic states and elsewhere.
It is therefore important to shore up the IMF and the World Bank, quickly. The IMF could be a helpful stabilizer in global financial markets if it had access to the sizable reserves of the surplus economies and if it pursued a philosophy more in keeping with the original Keynesian vision of those Bretton Woods organizations. To make this change possible, the Obama administration should offer the surplus economies a new Bretton Woods grand bargain: in return for making outsize contributions to the world economic recovery fund from which the IMF and the World Bank could draw working capital, the United States would support giving these countries a greater say in the running of the IMF and the World Bank.
Previous US administrations blocked efforts to increase the working capital of the IMF and the World Bank because the proposed measures threatened Washington’s pre-eminent position in these institutions–as well as its de facto veto, since increasing the allocations of Japan, Germany and other surplus economies in the G-20 would have increased their weighted vote. That has turned out to be shortsighted, because we have been left with cash-strapped and ineffective international institutions. That has put more burden on the Federal Reserve to use US monetary policy as a world crisis stabilizer, which contributed to the buildup of the large asset bubbles of the past decade. It has also left the door open for the big surplus economies to use their sovereign wealth funds to influence the course of world capital markets.
An emergency world economic recovery fund would enable the IMF and the World Bank, along with regional development banks, to carry out a global macroeconomic stimulus program to supplement national fiscal expansion. The IMF could tap the fund to carry out currency stabilization programs and help countries manage balance-of-payments problems. The World Bank and regional development banks could tap the fund to accelerate lending for job-creating public works and social investment in developing countries. Fund money could also be made available to UN projects related to healthcare, education, nutrition and the environment. This increased social and public spending would help stabilize consumption and investment in vulnerable developing and emerging economies, and aid a global economic recovery.
The underlying rationale of such a global stimulus program is that it would be more effective and less potentially inflationary over the longer term than a solely domestic fiscal expansion. Just as important, such a world public-sector program, together with a new system of managing world currencies, would point the way to the institutional reform needed to correct the many failings of the globalization of the Clinton-Bush era.