Last year, the world economy grew by 5%1 , its fastest rate for many years, led by the extraordinary boom in China and very high growth in most other third world countries too. America and Japan also had fairly strong growth, although Western Europe had a more dismal performance. Can the good times last? Or is the world economy heading for a crisis?
The world economic boom has been driven by two factors.
In part it has been driven by a gradual liberalization of world trade and a liberalization of major third world economies like China and India. The average tariff level in a country like China has been lowered from 41% in 1992 to 6% in 2004. The increased liberalization of world trade has increased the scope of international division of labor and permanently helped raise growth in the world as a whole and in particular in third-world countries. Particularly if trade is freed even more, this factor should continue to help the world economy to prosper. Another reason for the increased growth in emerging economies is the free market reforms implemented there with a country like China transforming itself from one of the most destructive communist systems in the history of mankind (that is saying a lot) to a virtual “capitalist paradise” with a seemingly endless supply of cheap but competent labor and with no welfare state and no unions and with many other emerging economies also undertaking free market reforms of varying radicalism.
But there is also a darker side to the current boom. It is to a high degree driven by the cheap-money policy of the Federal Reserve. And it is not just the American economy which rests on this shaky foundation. Most other economies in the world are also dependent upon the cheap money policies of the Fed. This is partly because the rest of the world has grown increasingly dependent upon the rising trade surplus with America created by the excess demand in America spawned by Fed policy and partly this is because the downward pressure on the dollar created by the low interest rates has made other central banks emulate the cheap money policy of the Fed in order to prevent their currencies from rising too rapidly in value against the dollar. Moreover, world economic growth is also dragged down by structural problems in Europe and Japan.
To better understand the prospects for the world economy, we should analyze in more detail the strengths and weaknesses of the four main economic powerhouses of the world: the United States, the European Union, Japan, and China. As they are the main driving forces behind overall movements in the world economy, it makes sense to focus on them. There are some other fairly large emerging economies like India, Brazil, and Russia which will also be briefly discussed.
We begin with the American economy. The American economy’s strong side is that it is still one of the most market-oriented economies in the world, with tax rates and regulation being far less burdensome than in the major European economies and Japan. It also has well-developed financial markets and institutions for higher education. This is what has helped America to remain the richest country in the world (apart from tiny Luxembourg) and to out-perform most other rich countries. Despite the best efforts of various American politicians to destroy these advantages, it will likely remain a positive factor for the next few years.
The Achilles’ heel of the US economy is its over-dependency on cheap credit. Five years ago, the US experienced its largest stock price bubble since the 1920s with valuations of technology stocks set at ludicrously high levels. This bubble was driven by rapid money supply growth and was accompanied by a sharp increase in the private sector debt burden and current account deficit, both of whom reached new record levels.
The private sector financial savings rate which usually fluctuates in a counter-cyclical way, having fluctuated between a surplus of roughly 5 % of GDP during recessions and around zero during booms, has now dived sharply into negative territory at –6% of GDP.
When the bubble burst in the spring of 2000, the US Economy seemed, given that background, set for a sharp recession. But the 2001 recession that followed the burst stock price bubble was very mild. The avoidance of a severe recession was achieved by a combination of combined tax cuts and spending increases, and the fastest and largest interest rate cuts ever in American history, with real interest rates being pushed into negative territory for the first time since the 1970s.
But this successful avoidance of a deep recession came at the price of preserving and indeed aggravating the imbalances that created the 2001 recession. The end of the stock market bubble was followed by the creation of another bubble, this time in housing. Normally during recessions the private sector debt burden falls and household and corporate balance sheets are restored through high net savings. But while corporate balance sheets have been repaired as a result of a sharp decline in business investments and record corporate profits, households have been on an unprecedented spending spree, households are more indebted than ever and saving even less than 5 years ago.
As a result of the budget deficit and the household spending spree, this time contrary to the normal developments during a recession, the current account deficit increased to new record levels, the private sector debt burden continued to increase while the private sector financial savings rate in a completely unprecedented way remained weaker during a recession than it has previously ever been even during a boom. And since the economy recovered from the recession, the build-up in debt levels have of course continued to increase.
Thus, apart from the fact that stocks are now far less 
overvalued than they were five years ago and that corporate balance sheets are now stronger, the fundamental imbalances in the U.S. economy are in fact even greater now than they were then. This makes the US economy vulnerable to another economic downturn. And this time imbalances are even greater and the means for politicians and central bankers to mitigate the crisis will be more limited since interest rates are much lower and the budget has a deficit instead of a surplus.
So, when will that crisis come? Pinpointing an exact date is of course impossible. It will be when the foundation of the current boom, that is the super-low interest rates, is removed and/or the imbalances become so great that they will fall under their own weight. It can also be said that it will likely not be during the coming year. While there are some signs that the housing boom has started to slow, this will be counteracted by the likely continued boom in business investments.
With corporate profits at near record levels, with interest rates still being far below their historical average and with business investments still being below the historical average, this means that not only do companies have the cash-flow needed to finance increased investments without much external capital, but more importantly that the return on investments is at a record high, so there is a strong incentive to increase investments.
The downturn to this is that it will likely contribute to a continued widening of the current account deficit and private sector debt levels.
So in conclusion, while we can be fairly optimistic about the US economy in the short run because of the likely boom in business investments and in the long run because of its still comparatively market-oriented economic structure, the imbalances created by the Fed’s cheap money policies make a sharp recession likely in the medium-term outlook. However, if this likely sharp recession will induce an extremely destructive response in the form of protectionism, higher taxes and spending, or high inflation it could make the long-term outlook more pessimistic.
Europe has for a long time lagged behind America and most other countries in growth. Or at least, the European Union as a whole. There are of course great differences between different European countries. It is mainly the big three Euro-zone countries, Germany, France, and Italy which have had dismal growth. Britain and Spain have had much stronger growth, while Ireland and Luxembourg have had outright exceptional growth. But because Germany, France, and Italy stand for more than two thirds of the Euro-zone economy while Ireland and Luxembourg are the two tiniest Euro-zone countries, their economies are more or less synonymous with the development in Europe as a whole.
There is of course a widespread myth that the cause of Europe’s economic problems are a too tight monetary policy by the European Central Bank. This claim is repeatedly brought forward by both politicians in various countries and the European business press. And Larry Kudlow even accused the ECB of pursuing a “scorched-earth deflationary” monetary policy. Yet this reputation of the ECB as being some kind of hard money bastion is (unfortunately) completely false. The ECB has consistently exceeded its own targets for money supply growth and inflation. During its 6 years of existence, M3 has increased at an average rate of 6.7% versus its target growth rate of 4.5% and the consumer price inflation has been an average of 2.2% versus its supposed target of below 2%. In the end of 2004, short-term interest rates were negative, consumer price inflation was 2.4%, M3 growth 6.4% and Private sector debt growth 6.9%. The reasoning behind ECB’s false reputation as a hard money bastion seems to be the false syllogism of “weak growth is the result of tight monetary policy. Europe has weak growth. Therefore Europe must have a tight monetary policy.” But as the first premise is false, so is the conclusion of the syllogism.
Instead the cause of Europe’s weak growth has two, to a high extent connected, roots.
One, its high government spending and regulatory burden which is far more burdensome than in America and China.
And second, the rapidly aging population in Europe as a whole and particularly in Germany and Italy. In countries like Germany, France, and Italy, the standard age of retirement is somewhere between 55 and 60. With the median age in Germany and Italy expected to be nearly 55 in 2050, this would imply that there would be far more old age retirees than people in the working age population. Combined with the large number in the working age population who live off welfare, this will imply a fiscal collapse and a large decline in the supply of labor and capital. This process is already taking its toll, particularly in Italy and Germany. Of course, an aging population needn’t necessarily be a problem for the economy, provided the average retirement age rises at the same rate as the median age. But raising the retirement age has proven to be very difficult. When the government of France raised the retirement age for government employees from 55 to 57.5 in the summer of 2003, it caused large-scale protests and strikes and any politicians who try to raise the retirement age are likely to face similar large-scale protests and strikes and possibly be voted out of office by the welfare-state addicted public.
But unless the European politicians take drastic measures to stop the demographic implosion, boost employment, and raise the retirement age, this problem will continue to get worse with time.
Germany has recently taken some timid measures to lessen its very high regulatory burden and its high unemployment benefits, but these measures are probably not sufficient to reinvigorate the German economy. The outlook for the European economy is therefore pretty pessimistic. Unless European politicians dramatically change their welfare statist policies, Europe looks set to continue its relative decline both in the short- and long-term perspective. And any decline in the American and Asian economies and a continued decline in the value of the dollar, would damage the European export industry and thereby deprive Europe of the one source of strength it has had until now.
The one bright spot for Europe is the inclusion of the fairly free market–oriented East European economies whose tax rates are very low not only compared to Western Europe but also compared to the United States. Not surprisingly this has led to very fast economic growth. And as the East European countries have become a part of the EU they will prop up overall growth. Moreover the increased tax competition from Eastern Europe has already started to prompt some West European countries to lower taxes, particularly corporate income taxes, which will boost their competitiveness. If the East European example prompts the West European countries to radically lower taxes and cut welfare spending then the outlook could be a lot brighter. But unfortunately that does not seem very likely.
Japan was for a long time the rising star in the world economy, greatly outperforming both Europe and America. But after the great stock- and real estate bubble in Japan in the late 1980s crashed, the Japanese economy has been stagnating with growth rates even lower than in Europe.
This has been largely because the banking system has been inhibited by the great mass of bad loans. The Japanese authorities have been unwilling to take on the short-term pain associated with liquidating the bad loans and have instead gotten a prolonged stagnation. Japan also shares many of Europe’s problems.
While Japan has a much lighter tax burden than Europe, its regulatory burden is, if anything, worse. And the inflexible economic structure created by the high regulatory burden has made the reallocation of resources from the inefficient companies created by the inflationary boom more difficult than in America. For this reason the high regulatory burden creates much more of a problem for Japan now than it did before 1990.
Japan also faces an even worse demographic problem than Europe. Already Japan has more people aged 65 or older than people younger than 20, something which only Italy also has. And it will get a lot worse. As there are less than 24½ million Japanese below the age of 20 while there are 35½ million in the age group 45–64, this means that the Japanese working age population will shrink by more than 11 million or 14% during the next 20 years, while the total population is expected to shrink by only a few million. As in Europe, this will create an enormous fiscal burden and decrease the supply of both labor and capital unless the retirement age is raised. Something which in turn will ensure a rather dismal growth rate.
One bright spot in the Japanese economy is the rise of China. The geographical proximity of China means that the Japanese stand to benefit more than western economies from the increasing division of labor with that country. Already China has surpassed America as its greatest trading partner. Japan has however recently seen its export growth to China sharply reduced as a result of the Chinese government’s successful efforts to restrict credit expansion. But in the long run Japan should stand to benefit more from the rise of China than America and Europe.
Another bright spot is that Japan will also benefit from the fact that its private sector has greatly reduced its debt burden, with corporate debt at its lowest level in over 30 years. This means that Japanese companies do not risk another economic bust resulting from tightening credit conditions.
Its medium term outlook however is clouded by a possible crisis in America and its repercussions on China and the rest of the world. And the demographic collapse and the falling supply of labor and capital it implies will put an increasing burden on the economy.
Since Deng Xiaoping, China has started to liberalize its economy and as a result has experienced extraordinarily high growth. After having been ravaged for centuries by British and Japanese imperialists, by a devastating civil war, and by 30 years of Mao Zedong’s brand of communism, China has started to regain its former status as an economic power house.
According to official GDP statistics converted at current exchange rates, China’s economy is still smaller than that of Britain. Yet that number greatly underestimates China’s true size as it does not take into account that the price level is far lower in China than in Britain. In all indirect indicators of economic size, the Chinese economy is far larger than the British. China is, for example, the biggest consumer of coal, steel, and many other commodities and the second biggest consumer of oil (after America). It is also the third largest trader in the world, after America and Germany. China is clearly already much more important for the world economy than Britain and will become even more important in the future.
There is every reason to believe that China will continue its extraordinary growth rate for at least the coming decade. With no welfare state, no labor unions and an enormous supply of both labor and savings, “communist” China is a capitalist’s paradise. And as is evident in the success of ethnic Chinese businesses in Hong Kong, Taiwan, Singapore and the rest of South East Asia, the Chinese have a strong entrepreneurial spirit. And with communism no longer suppressing this, the potential for growth is enormous.
While estimates of the number of farmers in China vary greatly depending on whom you ask, even the lowest estimates reckon that at least half of China’s 1.3 billion people are still farmers. If the relative size of the agricultural sector falls to western levels this means that more than 600 million people will be heading for employment in the industrial and service sectors. And 600 million is twice as many as the population of the United States.
Combine that with the fact that China has perhaps the highest savings rate in the world and thus will be able to make the investments necessary to continue its high growth rate. As The Economist disapprovingly noted, this high savings rate is to a large extent caused by the lack of a welfare state since this forces people to save if they wish to have enough money to for example pay medical bills.
Of course, there are potential dangers for China which could at least temporarily derail its strong growth. The fast transition of the country could potentially create great social unrest. The Chinese banking system looks very fragile as it is heavily burdened by bad loans. Moreover, China is far too dependent on exports to America. China’s exports to America last year were some 12% of GDP and the bilateral trade surplus was 10% of GDP.
This makes China very vulnerable to an economic downturn in America. First because of its direct negative effect on exports and second because China is likely to be blamed for the crisis which could create a protectionist backlash which will severely damage the Chinese economy. A revaluation of the yuan would be one good way for China to reduce its dependence on exports to America. While it would create some negative short-term effects in the form of reduced exports and reduced value of assets in America, it would also lower the cost of imports. And most importantly, China would both lessen the risk of protectionist measures as the charge of “manipulating” its currency (as if there are any currencies today that aren’t manipulated) would go away and it would also reduce the damage caused by the protectionist measures as the higher dollar value of the economy of China created by the revaluation would lower the relative importance of exports to America.
Moreover, China potentially faces a conflict with America over the secessionist “break-away province” of Taiwan.
China’s outlook is very good as long as they avoid any of the previously mentioned dangers.
This means that while the short-term outlook for the Chinese economy is strong, it risks heavy damages from any economic crisis in America, something which in turn poses risks for social unrest and for the fragile banking system. If China manages to get through that crisis without the outbreak of a civil war, the reversal of market reforms, or dramatically increased western protectionism or a war over the issue of Taiwan, it should thereafter be able to resume its impressive growth.
The story for some of the other major emerging economies, like Brazil, India and Russia, have many similarities with that of China as they have also started to liberalize their economies, something which has helped boost their growth rates. Their potential may not be as great as that of China because their cultures are not as inclined towards thrift and entrepreneurship as the Chinese culture and because in the case of Brazil and Russia their populations are much smaller and in the case of Russia shrinking. India is also still plagued by the unofficial caste system which makes it more difficult to spread the success to the entire population than in China. The Russian and Brazilian economies are also to a dangerously high extent dependent on oil and agriculture respectively. Even so, they and many other emerging economies will likely increase in importance.
For the world economy as a whole, we should in the short-term outlook expect the current boom to continue but at the price of aggravating the global economic imbalances. America’s debt burden will continue to rise while the rest of the world will grow increasingly dependent upon exports to America. In the medium term, a strong rise in real interest rates and/or falling confidence in America will trigger a recession there which will spread throughout the world in the form of falling exports to America, both because of the direct reduction in demand created by the recession and the indirect effects of a falling dollar and possibly outright protectionist measures. This will add to and aggravate the domestic problems in the rest of the world.
In the longer term, we will likely see a great shift in the world economy with China and other emerging economies increasing in importance while Europe and Japan gradually decline in importance. Because of the problems in the European economy, it seems unlikely that the euro will replace the dollar as the world’s reserve currency. However, in a longer term perspective (meaning a few decades from now) the Chinese yuan might take over that role when the yuan becomes fully convertible and when China becomes the world’s largest economy.
- 1If you weight the world’s economies adjusted to the local cost of living. Weighted by current exchange rates would give a too low weight to rapidly growing but still poor countries like China and India and accordingly lower the world growth rate.
