Bernanke (2005) had argued that the low level of US interest rates implied the latter rather than the former. Bosworth and Flaeen (forthcoming), however, show results suggesting that this view cannot be supported.
They add that it is not evident that imbalances should translate into a strong impact on the level of global interest rates.
The other view is that lax monetary policy contributed to the crisis. Global liquidity, measured by the ratio of the broad money supply (M2) to nominal GDP ratio in the US, Western Europe and Japan, has been increasing since the first quarter of 1999, reflecting the easy money stance. This led to the lowering of interest rates which encouraged investors to invest in risky assets to obtain higher yields. The result was an asset bubble in the US, especially in the mortgage market, and in a number of European countries.
Lax monetary policy alone is not a sufficient condition for creating a financial crisis. Lax prudential regulation at the microeconomic level encourages unwarranted financial innovation in times of lax monetary policy and together they contribute to a crisis. History shows that boom and busts have been associated with financial innovation.
In the current GEC, the main innovation was securitization of loans, especially mortgage-backed securities associated with the ‘originate-to-distribute’ model of banks in the US, with a supporting role played by credit default swaps, a kind of insurance against bankruptcy. Interestingly, rather than selling the securitized assets, banks held on to them in unregulated off-balance-sheet vehicles to circumvent the Basel I and Basel II capital adequacy rules so that they maintain less capital though the risk remains the same.
Even if crises occur in other economies, particularly in the large economies, with increasing globalization, Asia is likely to be affected in various ways, and hence cannot remain a passive bystander. For one thing, Asia needs to actively participate in reforming the international financial architecture so that it performs its global surveillance role more effectively.
Positive consequences
The global financial and economic crisis has had an unexpectedly large impact on Asian economies. The GDP growth rate for the region is expected to be only a little over one third of the 9.5 per cent growth rate Asia enjoyed in 2007.
But unlike a few months ago, when market sentiment was all decidedly gloomy, today many have started to become optimistic and claim that we will soon hit the bottom of the crisis. This is because, although output in many economies has continued to decline in recent months, the rate of decline has moderated. The debate has shifted to the shape of the recovery, and many now hope that we are going to have a V-shaped recovery.
This is not likely to be the case. Reinhart and Rogoff (2008) have shown that recoveries from financial crises for industrialized economies whose financial systems have been severely battered by the crisis seem be more gradual and could take several years.
Banks need to rebuild their balance sheets and restore public confidence before they can expand their lending activities again. Households need to rebuild their financial balance sheets to make up for the erosion of wealth during the crisis, and that means they have to reduce consumption and raise savings. For the US, consumption is likely to fall well below the 72 per cent share of GDP it achieved in 2007. Recent statistics suggest that this adjustment has already started to take place.
How about Asia? Although many Asian economies encountered financial stresses and liquidity shortages as the crisis deepened, they entered the crisis with relatively sound financial systems. Does this mean that they can expect a V-shaped recovery similar to that after the 1997-98 crisis?
Asia has never come out of recession through export growth at a time of weak growth in the US, as Gupta and Miniane (2009) demonstrate. With the expected decline in US consumption ratio and sluggish consumer spending in Europe, exports cannot be relied upon to pull Asia’s growth to pre-crisis levels it the way that it once could. Asia must itself work for rebalancing growth.
Rebalancing growth means altering the composition of aggregate demand in favor of internal demand, rather than external demand, matched by changes in the production structure in favor of non-tradable goods and services. On the demand side, many economies in the region have still room for increasing consumer spending, and one challenge is to remove obstacles to stronger spending.
Fiscal resources could be directed to strengthening social sector protection (including health, unemployment insurance and pensions) to reduce precautionary motive for saving. On the supply side, incentives that favor export-promotion and export-production have to be phased out. This does not mean a return to import substitution regime lest policymakers may be tempted to entertain the idea of introducing all kinds of industrial policy measures.
The current situation will also provide a stimulus to find ways to mobilize Asia’s high level of savings to support spending in the region. For example, there are still plenty of worthwhile infrastructure projects in the region. This includes promoting development of regional bond markets and developing institutions to facilitate funds transfers among Asian countries.
In short, the crisis will compel Asia to diversify its sources of growth, an accomplishment for Asia that can make it less vulnerable to external shocks and more resilient in the event of future crises.
The Great Depression challenged mainstream economic thinking in the 1930s and produced revolutionary economic theories and paradigms. If the severity of the current GEC has so far been unmatched since the Great Depression, it is likely to have similar effects on economic thinking and policy making. If there is a fundamental change in the way of economic thinking, global and national institutions, such as the central bank and macroeconomic policies, could change too.
Countries that followed strict inflation targeting are already reassessing that monetary framework to take into account other indicators that could contribute to a crisis. Economic models will then be more accommodating of the need to insure against risks. Finally, banking has become global but regulatory regimes remain national. This, too, must change if we are to learn from the recent experience of Europe.
This is a summary of the latest EABER Newsletter, which is available here.
Mario Lamberte is the Director of Research, Asian Development Bank Institute. The views expressed are his own.
I agree with most of Mario Lamberte’s arguments in the following paragraph:
“The Great Depression challenged mainstream economic thinking in the 1930s and produced revolutionary economic theories and paradigms. If the severity of the current GEC has so far been unmatched since the Great Depression, it is likely to have similar effects on economic thinking and policy making. If there is a fundamental change in the way of economic thinking, global and national institutions, such as the central bank and macroeconomic policies, could change too.”
But I think it is likely to be premature to infer too much from these arguments, no matter how useful they are. I think some of Mario Lamberte’s prescriptions need careful analysis. They include, especially things how to rebalance composition of GDP, the role of exports and the argument that to avoid future external shocks, Asian countries need to boost domestic demand and rely less on export, export incentives, how fiscal resources should be readdressed, changes in the production structure in favor of non-tradable goods and services, reducing precautionary motive for saving.
What I am concerned is that many people, including policy makers and advisers, have a tendency to overshoot in their responses to the great recession. My view is that an open and free trade international system will still be much more superior than self reliance and autarky. Benefits of trade and economic integration will outweigh the cyclic shocks that can be transmitted through an integrated international system, even though there are short term negative consequences if there are downward external demand pressures from time to time. Knee-jerking in the face of economic difficulties by throwing the baby out with bathwater is hardly ever a prudent strategy.
More specific comments are likely to follow.
This is my second comments on this article, but still a very brief one. I just make two quick points here. One is the different presentations of the GDP and the other is about trade and external shocks.
Firstly, the different presentations of the GDP identity. The following is two of the different measures of GDP:
C + I + G + E -M = Y = C + S + T + Rf
Where Rf is net transfer to other countries and all others are as their normal representations.
If one looks only at the right hand side, it is easy to be confused by the inevitable trade off between savings and consumption, a point made in that article. But if one looks at the left hand side, one can easily see that to address high propensity to save, it is not necessarily to increase consumption. Instead, an increase in investment can accommodate high savings. Indeed, in conventional cases, savings are generally equal to investment in a closed economy. So, if there are investment opportunities in an economy, to invest the savings can be an effective way and likely a better way than increasing consumption, especially when capital is comparatively scarce, as in most developing economies in Asia. That is way I found either myself is so dumb in unable to understand the point in the article, or the point in the article is so ill conceived to mention only the increase of consumption and little about investment to accumulate capital.
Secondly, the role of trade in a modern economy. Let’s have a look at the left hand side of the GDP identity above. What Lamberte was concerned is that exports, E may not be growing as fast as it had been prior to the current world economic crisis because the US and Europe are in serious trouble and the US will need to adjust its savings and consumption. As a result, the trade / current account balance may not contribute to economic growth for many Asian economies, so the argument went.
It is possible that may be the case for the foreseeable period in the near future. But it is by no means a completely foregone conclusion. The US needs to increase its savings, both private and public. But that may not necessarily mean that their absolute levels of consumption and government spending will always fall to realise that. It may be a long and slow adjustment process, in which private consumption and government may still rise but at a slower pace than its GDP. That is to say, the proportion of the net increase in GDP devoted to savings will be larger than its existing actual proportion, but there will still some left for an increase in consumption and government spending.
Second, trade with the US may still be able to expand even when the consumption in the US is not to increase but to stay constant or even fall. The requirement is an increase in the so called intra-industry trade. There is no requirement that economic growth is the necessary condition for trade expansion.
Third, assuming that the US has ceased to be an engine of the world economic and trade growth, then other economies may take a greater role in the expansion of world economic and trade growth. Yes, it would be nice if the US could indefinitely absorb exports of other economies, especially from Asian ones. But the pattern of the world economy has been changing and the contribution of the US to world economic and trade growth, though very important as it has been, has been on the decline and will continue to do so, and even at an increasing pace.
That itself does not equate to a call for the developing economies in Asia to increase their consumption to boost their growth. To the contrary, given the role of capital in economic growth and the relatively low levels of per capita physical capital in those developing economies, the most effective way seems to be to increase investment rather than to increase the proportions of consumption, for long term growth and catch up.
That is why I find it difficult to understand there are so may people, both economists or not, high ranking officials and advisers included, are calling for China and other Asian developing economies to increase their consumption to solve the so called international imbalance. Can’t we just simply have a look at the GDP identities and to have a sense of what is needed for economic development and catch up for developing economies? There are not too many variables there. Is that too difficult to do or comprehend? Why?
Let’s have a debate!
This is my third comment on this article.
I have just read the release of Australia’s March 2009 GDP data by the Australian Bureau of Statistics (ABS). What I have found is a strong support of the role of trade in the economy. GDP rose by an unexpected 0.4% in the March quarter. Guess what? The largest contribution to that growth was from imports, by 1.6%, on quarterly basis.
What does that say? It suggests that trade can contribute to the economy positively even if during a severe global downturn – in fact a great global recession, although one should recognise that seemingly it is a zero sum. But most people understand that the benefit of trade is never to be a zero sum game – it goes much further than the seemingly zero sum and is an increasing game.
Isn’t this amazing? For those who are wondering about and doubting the role of trade and exports in the face of the recession, they need to think again and hard. On that account do we really need any more new economic thinking or new development or growth paradigms?