It is now widely acknowledged that the world economy is going through a global recession, the likes of which we have not seen in eight decades, and the inability to rely on export stimulus anywhere also makes it evident that no single country or group of countries can emerge from the crisis on its own. Cooperation among industrialized and emerging economies and coordination of policies across the board are essential. Because the current crisis originated in the US and European financial systems, policymakers have tended to focus their attention on banking and financial market issues. Indeed, governments in the developed world have adopted a series of urgent rescue and stabilization plans to avoid the collapse of financial system. As part of this, agreement was reached at the April G20 summit to increase IMF resources to meet short term financing needs of developing countries facing currency crises.
This article argues that the main challenge of the global crisis has turned from solving the problems in the financial sector to tackling those in the real sector, specifically the issue of the large excess capacity to produce output. Persistent capacity under-utilization in the real economy will result in a downward deflationary pressure, deterioration of balance sheets in the financial and corporate sectors, and a higher risk of protracted global recession and currency crises in some developing countries. The existence of excess capacity on a global scale calls for a Keynesian type of globally coordinated fiscal stimulus, in both high-income and developing countries. However, to make the fiscal stimulus work, it is necessary to go beyond the conventional Keynesianism, by focusing on “bottleneck-releasing” projects, and to go beyond national boundaries, by supporting developing countries’ stimulus efforts with loans from developed and reserve-rich countries.
Boom, Bust, and Excess Capacity on a Global Scale
The current crisis was preceded by six years of a boom in the global economy. Its origins can be traced to the burst of the Internet bubble in 2001 and the subsequent expansionary monetary policy pursued by the US Federal Reserve, as well as the high leverage in the financial sector as a result of financial deregulation. Deregulation had led to low interest rates and excess liquidity, contributing to the large increase in real-estate and equity investments in the United States, as well as to an unprecedented increase in private capital flows to developing countries, supporting their investments in the manufacturing sector. Financial innovations helped stoke the boom in the housing and equity markets, and as markets surged, wealth effects prompted households to divert a steadily increasing share of their income to consumption. Many households even decided to monetize their assets, most often housing, to fund further consumption. Borrowing ballooned. US household debt as a percentage of annual disposable personal income (gross income minus income tax) increased from 77 percent in 1990 to 127 percent at the end of 2007. Household final consumption expenditure (a price index which represents consumer spending) surged from just over 67 percent in 1997 to 70 percent in 2001 and remained over that level afterwards. The boom in mature economies further fuelled the stoking of growth in emerging markets, through increased export revenues and higher commodity prices, a surge in foreign direct investment, and increased remittances from abroad.
Growth increased export demand sharply, so that developing country exports accelerated even beyond their rapid growth of the 1990s. The flow of foreign direct investment to developing countries soared as investors sought higher returns than they could earn domestically, given the low yields that prevailed in mature economies at the time. Net private capital flows to developing countries increased from US$200 billion in 2002 to a record US$1 trillion in 2007, while remittance flows to developing countries also increased by about 18 percent per year to US$305 billion in 2008. The rapid increase in sources of financing led to an investment boom in many developing countries, especially the emerging markets. The growth rate of investment in developing countries rose from 1.6 percent per year in the 1980s to 2.9 percent in the 1990s and 11.9 percent prior to the current crisis. The investment boom in turn stimulated developing-country demand for capital goods from the United States, Japan, and other developed economies, further fueling the growth there. This self-reinforcing cycle and the direct effects of investment allowed the developing world to achieve some of the highest growth rates in decades. From 2003 to 2007, the collective GDP of developing countries grew more than 5 percent each year; in 2006 and 2007 the growth rate peaked at nearly 8 percent, with all developing regions close to or exceeding 5 percent growth. By contrast, average annual growth for 1980-2000 had been just 3.4 percent. In the United States demand was stimulated by the substantial swing in the US fiscal position, from a small surplus in 2001 to a sizeable deficit in 2003, which, combined with a low interest rate and low saving rate, contributed to large US current account deficits and higher demand for developing-country exports. This stimulated further demand for investment goods in emerging markets and demand for capital goods in industrialized countries. The combination of abundant investment capital and rapid growth helped to inflate real estate prices to bubble-like heights in some emerging markets. Many equity markets surged as well.
As we know, the boom ended mid-2007 with the bursting of the US housing bubble and the onset of sub-prime market crisis. Following the collapse of the large investment bank Lehman Brothers in September 2008, the value of capital eroded dramatically, undermining the creditworthiness of major global financial institutions and triggering massive de-leveraging. Efforts to restore capital adequacy and uncertainty about the underlying value of assets held in the form of sub-prime mortgage-backed securities resulted in capital hoarding, causing liquidity to dry up. The ability of borrowers to finance transactions in both the real and financial sectors diminished. This in turn reduced demand and employment, undermining consumer and business confidence, and triggering a further contraction in demand.
Meanwhile, the total capitalization of world stock markets almost halved by the end of 2008: US$40 trillion of wealth in equity has disappeared. In the United States alone, the wealth losses for households related to the fall in home prices are roughly US$4 trillion so far, and are clearly bound to increase further as home prices continue to fall, possibly one day reaching a US$6-8 trillion range. Losses of this magnitude also have significant wealth effects on consumption and savings. Many of the investments made during the 2002-2007 global boom now serve as excess capacity on a global scale. Evidence has emerged of a substantial fall in industrial production in many high-income countries and emerging economies. The industrial capacity utilization rate declined down to 69 percent in March in the United States, the lowest level since records began in 1967. It fell to around 60 percent in Japan and near 50 percent in some developing countries.
In the same month, US headline Consumer Price Index (the standard measure of inflation) has recorded its first decline of 0.4 percent since 1955, while deflation has also hit Japan, Korea, China, India, and many other countries. Empirical research suggests that such excess capacity and downward deflationary pressure may have long-lasting, negative effects on corporate profits, investment, employment, wages, and consumption, further reducing aggregate demand (the total amount of goods and services demanded in the economy at a given overall price level and in a given time period) and triggering a deflationary vicious cycle, which takes place with the expectation of future earning drops and people defer buying while businesses defer investing.
The Impact on the Developing World
Despite early hopes that emerging markets and developing countries might be protected by the “decoupling” trend that had characterized their growth in the past few years, the developing world has felt the full hit of the crisis in the real sector, which followed the financial crisis. Declining growth rates combined with high levels of initial poverty leave many households in developing countries highly exposed to the crisis. At the same time, government constraints in cushioning the impacts due to limited institutional capacity and fiscal resources are heightening vulnerability. According to recent estimates, developing countries will experience a financing gap in a range of US$270-$700 billion, depending on the severity of the economic and financial crisis and the strength of global policy response. Existing resources of international financial institutions cannot cover the shortfall, even at the lower end.
The supply of capital from private sources is much tighter than in the past, resulting in higher interest rates and spreads, and lower capital flows than over the past five years. While international financial markets are bound to present different features than those which prevailed over the past 25 years, these changes may have far-reaching consequences for the way global savings are allocated to developing countries. The disappearance of many institutions that helped intermediate between savers in developed countries and investment opportunities in emerging markets is destroying the fabric of global finance. At the micro level, households in almost all developing countries are facing increased risk of poverty and hardship. Initial estimates for 2009 suggest that lower economic growth rates will trap 53 million more people on less than US$1.25 a day (the critical level of spending that a poor person would deem to be adequate in order to escape absolute poverty) than was expected prior to the crisis and the number will be 65 million if the standard is raised to $2 a day. The social impact of the crisis on developing countries will be very serious. The effects of falling real wages and joblessness impede households’ ability to provide adequate food and necessities to their members.
The ILO (International Labor Organization) projects that unemployment will increase by 30 million worldwide in 2009, 27 million of which is in developing countries. Absent assistance, households may be forced into the additional sales of assets on which their livelihoods depend, withdrawal of their children from school, forgoing necessary health care, and cutting back on food, which could risk malnutrition. The long-run consequences of the crisis may be more severe than those observed in the short run, possibly turning a short-run macroeconomic adjustment into a long-term development problem. When poor households pull their children out of school, there is a significant risk that they will not return once the crisis is over, or that they will not be able to recover the learning gaps resulting from lack of attendance. And the decline in nutritional and health status among children who suffer from reduced (or lower-quality) food consumption can be irreversible. The middle class will also be hit hard by soaring joblessness, losses in equity markets, possible currency depreciation, and anxiety over the safety of local banks.
Constrained by already eroded fiscal space and by foreign exchange reserves, many developing countries will be unable to implement counter-cyclical policies on their own. Moreover, the crisis is reducing their income, thereby worsening public finances, threatening existing levels of spending, and further reducing services to the poor. We are facing nothing short of a development emergency. From “Shovel-Ready” to “Bottleneck-Releasing” The current crisis originated in the US and European financial systems. Policymakers have tended to focus their attention to the urgent need for rescue and stabilization plans to avoid the collapse of the financial system. The main achievement of the April G20 summit was to increase IMF resources to meet short term financing needs of developing countries facing currency crises due to the drying up of private capital flows. However, at this stage of the crisis, solving the problems at hand would require much more than the restructuring of credit and financial markets, and avoiding a currency crisis in the developing countries.
With the existence of excess capacity, efforts to increase bank lending may be futile because of firms’ lack of good investment opportunities and households’ lack of confidence about their future job security. The consequent increase in non-performing loans and the risk of more assets becoming toxic could jeopardize efforts to stabilize the financial sector. Even if it were possible to restore confidence within the financial markets and to unclog the channels of credit, increasing money supply by lowering interest rate would not be effective to stimulate demand: excess capacity in developed economies implies limited profitable investment opportunities, high unemployment rate, pessimistic expectations, low confidence about the future, and the likelihood of a liquidity trap. Addressing excess capacity calls for bold action on the fiscal front and the April London G-20 summit recognized the needs for a global coordinated fiscal stimulus. As currently designed, recently announced fiscal stimulus packages typically aim to stimulate short-term growth demand by frontloading the financing of “shovel-ready” projects (those that have completed all necessary design work and are ready to be put out to bid). This is can be seen as a simplistic application of what is viewed as a Keynesian stimulus, where consumption spending by individuals and investment spending by businesses drive the economy, and the government can add to total spending by running a budget deficit, either by purchasing goods and services or by reducing taxes. While there is urgency may demand the in designing of stimulus packages, we cannot shying away from the question of their effectiveness cannot be feasible either. Evidence that increasing public spending can generate a multiplier effect strong enough to effectively counteract a deflationary spiral is scant at best.
On the contrary, the theory of Ricardian Equivalence (from nineteenth century economist David Ricardo) points out the possibility that, in anticipation of the need to pay for the fiscal deficit in the future, households may increase their savings, offsetting the impact of fiscal stimulus on aggregate demand. During the “lost decade” Japan’s government implemented very aggressive fiscal stimulus policies. In 1991, public debt represented 60 percent of the country’s GDP. By 2002, it had increased to about 140 percent—implying a very large and very decisive stimulus of 7 percent of GDP per year. Yet, Japan did not get out of the crisis. Households chose to save more, which dampened the effects of government spending. We need to face the reality that current fiscal stimulus policies could be plagued by the same failure. In his study of the impact of fiscal policy in the United States during war time, Harvard’s Robert Barro, a skeptic of fiscal stimulus packages, estimated that World War II raised real GDP by US$430 billion per year (in 1996 prices) in 1943-44, with a multiplier of only 0.88. In other words, for each extra dollar of Government spending, GDP rose by only 88 cents.
China’s economic stimulus of 1998-2002 provides an example of a successful fiscal policy strategy that targeted binding constraints on productivity growth, achieving a stimulus through enhancing long term growth. In the midst of the Asian financial crisis, when sharp economic slumps in Indonesia, Korea, Malaysia, Philippines, and Thailand prompted widespread currency depreciations in the region, the Chinese government issued an estimated RMB660 billion in bonds specifically to finance infrastructure, with a focus on releasing bottlenecks to growth. These included the highway system, port facilities, telecommunications, and spending on education. Highways in China grew from 4,700 km in 1997 to 25,100 km in 2002. China went through deflation and still recorded an average growth rate of 7.8 percent—the highest in the world at that time—and got out of deflation in 2003. Average annual GDP growth reached 10.8 percent in 2003-2008, 1.2 percentage points higher than the average annual growth rate of 9.6 percent in 1979-2002. The corresponding increase in government revenues allowed public debt to decline from about 30 percent of GDP in the 1990s to about 20 percent in 2007. When examining the impact of fiscal stimulus, it is important to note that public infrastructure investment has the highest short-run multiplier.
Tax cuts on the other hand are likely to have minimal multiplier effects particularly in the current environment, as households may save a proportion in anticipation of future tax increases. Meanwhile, the relevant lesson from Japan’s experience is clear: even if governments around the world agree to spend the package on public infrastructure, the issue remains of whether these fiscal programs will increase aggregate demand enough to offset the excess capacity accumulated the 2002-2007 bubble. The Chinese experience suggests that if public spending is invested in projects that release the bottleneck of growth, the investments will generate high enough future returns to pay for their costs, rational economic agents will not be taxed for repayment, the Ricardian equivalence effect will not exist, and the chance of a large multiplier effect and successful fiscal stimulus is high. To overcome this financial crisis, globally synchronized efforts are needed. High-return public infrastructure investment opportunities abound in developing countries as infrastructure is their main bottleneck of growth.
Release of evident bottlenecks in developing countries would result in enhanced growth potential, higher marginal returns to private sector’s investment and finally to higher government revenues to pay for the projects. While such bottlenecks are the best investment target for effective fiscal stimulus, many developing countries are constrained by their fiscal space and availability of foreign reserves. These constraints that bring into question the feasibility of the traditional Keynesian macroeconomic policies. Clearly, an effective globally coordinated fiscal stimulus should address these constraints, mobilizing financial resources to be injected from developed and reserve-rich countries to developing countries. Loans from developed to developing countries to finance high (economic and financial) return projects can lead to a win-win situation as they will enhance the growth potential and increase sustainable demand in the long run.
By supporting investment in infrastructure bottlenecks that constrained economic growth in developing countries, the coordinated fiscal stimulus would have a large multiplier effect, raising the chances for the global economy to avoid becoming trapped in a downward deflationary spiral. At this stage, solving the problems at hand would require more than the restructuring credit and financial markets. Before the crisis, excess liquidity contributed to the boom in real sectors. In the face of excess capacity and deflation, the financial sector cannot be stabilized because more assets will become toxic and more loans non-performing. We must advance beyond conventional Keynesianism and transcend national boundaries to create a globally coordinated fiscal stimulus.