Themes > Features

02.05.2000

World Economy : Instability at the Core

In a move of some significance, George Soros, the much-celebrated financial czar of the "new economy", has announced his decision to retire into philanthropy. The hedge fund master, who through his Quantum Fund, drove market sentiment, placed and quite routinely won big bets in currency and stock markets, and challenged sovereign nations and their governments, has been badly bruised by two developments: the sharp fall of the Nasdaq index and the weakening of the Euro. We must recall that by April 14, the Nasdaq index fell by 34 from its March 10^th peak, and even now rules at around 25 per cent of that level. And the euro has depreciated by around 10 per cent this year. Unfortunately for Soros and his managers, the Fund failed to pull out of technology stocks in time and erred in their judgment on how the euro would move. In the event the Quantum Fund lost around 20 per cent of its value (or around $5 billion) in the first four months of this year. A chastened Soros has decided to restructure his operations, rename his company Quantum Endowment Fund, invest in less risky assets that promise a stable return, and use the proceeds for his charitable activities. The markets are proving too volatile even for a player who built his empire over three decades by exploiting that volatility to garner annual returns in excess of 30 per cent.
 
This development is more then incidental, because in a world dominated and driven by finance, the change in sentiment that the Soros decision heralds, can be quite damaging. Yet, the Bretton Woods institutions and those who manage current day capitalism exude a new confidence. Underlying that confidence is the performance of the US economy in recent years, besides the deficit-financed recovery in Korea and Thailand. As compared with an annual average rate of growth of GDP of 2.9 per cent during the decade 1982-91, the US economy has expanded at an average rate of 3.6 per cent during 1992-99 and 4.2 per cent during the last three years (Chart 1). Moreover, there have been only 2 years during the 1990s (1993 and 1995) when growth in the US has been lower than it had been on average during the 1980s. Such growth has helped reduce unemployment from 7.0 per cent during the 1980s and 7.5 per cent during 1992, to 4.2 per cent in 1999. And despite high growth, inflation in the US runs at 1.2 to 1.5 per cent, as compared with 3.7 per cent during the 1980s. A change in its inner nature, protagonists of the new economy argue, has made a combination of high growth, low unemployment and moderate inflation the norm under capitalism.

It is not too difficult to discover the obvious flaw in this argument. While the US does constitute the leading power, both economic and political, in the world system, it is hardly representative of the whole. In fact, a striking feature of the 1990s has been a combination of slower growth and substantial unevenness in the advance of the world economy. To start with, the 1990s have been characterised by slow growth in Japan and across much of the world. According to the World Economic Outlook, the average rate of world economic growth during the 1990s was only 3 per cent, which is below the 3.5 per cent average of the 1980s and the 4.5 per cent of the 1970s. The figures for 1982-91 and 1992-1999 stood at 2.6 and 1.9 per cent respectively in the case of the European Union and 4.1 and 1 per cent in the case of Japan. World trade growth, which accelerated from close to 4 per cent in the year 1992-93 to more than 8 per cent on average over the next four years, rendering national growth rates less significant, is back to its earlier levels over the last two years (Chart 2).

Looked at from the point of view of unemployment, the US reflects a phase of near continuous buoyancy with declining employment rates (from 7.5 to 4.2 per cent) starting in 1992, but Japan has recorded a continuous increase in unemployment rates from 2.1 to 4.2 per cent between 1991 and 1999, Germany from around 6 to over 9 per cent and France from 9 to 11-12 per cent (Chart 3). Thus within the developed "triad", the good days seem to be large confined to the workers in the US, and to an extent in the UK.

Further, there are signs of an increase in instability both in the financial and the real realms of the world economy. The instability in the financial sector, noted at the beginning of this article, has been widely reported by the media. But in the real realm too, besides the two phases of significant slowdown in economic growth (in 1991-93 and 1998-99) over the decade, and the crises in Mexico, East Asia, Russia and Brazil, the 1990s have closed with extreme weakness in Japan, despite repeated efforts to revive the economy with lower interest rates and large deficits. Figures reported in April this year suggest that restructuring efforts by Japanese firms have not merely kept unemployment at its post-War high of 4.9 per cent, but unemployment among males rose by 0.1 percentage point that month to touch 5.2 per cent and that unemployment among males aged 15-24 rose by 0.8 per cent year-on-year to touch a record 12.5 per cent.
 
This combination of slower growth, greater divergence in growth and increasing instability, stems precisely from the growing role of finance in the international system. There are a number of features of this rise to dominance of finance, which have been noted earlier in these columns. Despite talk of a new architecture, the global financial system remains highly centralised, with a few US financial institutions intermediating global capital flows. Decisions by a few agents determine the "exposure" of the system, which appeared to work well, till reports of the near collapse of Long Term Capital Management came in. The Soros development indicates that was not an isolated instance. The adverse role of individual decision-making is illustrated here as well. As Stanley Druckenmiller, a senior executive at Quantum Fund reportedly put it: "I screwed up. I should have got out in February … This business is a bit like a drug. When you are doing well its hard to quit.". Unfortunately, unregulated entities run by intoxicated individuals making highly speculative investments are at the core of the system.
 
Further, with financial firms betting on interest rate differentials and exchange rate changes at virtually the same time, the various asset markets relating to debt, securities and currency are increasingly integrated. Developments in any one of these markets affect the others as well. It is in this light that the trends in interest rates have to be assessed. As Chart 4, which provides the trends in short term interest rates suggest, since the early 1990s, interest rates in the US have risen, while those in Germany and Japan have fallen. This has meant that the interest rate parity between the US, Japan and Germany in 1990, has given way to a situation where US interest rates rule much higher than in the other two countries, the gap is in fact tending to widen. Since inflation rates (Chart 5) in the US have tended to converge, while those in Japan have fallen, the real interest rate differential has widened even further.

Such interest rate differentials accelerate capital movements in a world of increased cross-border financial flows. Higher interest rates in the US relative to Japan, have resulted in capital flows to the former and contributed to a combination of asset price inflation and exchange rate appreciation. The resulting high returns on dollar-denominated assets proved self-reinforcing, till expectations of a decline in asset prices came to dominate investor behaviour recently. The US became a major target of non-US based investors. For example, foreign purchases of US Treasury and government agency bonds are reported to have reached $293.7 billion in 1996, and there was a further $78 billion of foreign purchases of corporate bonds. This trend has persisted since then. A large part of these investments were based on borrowed yen funds, aimed at taking advantage of interest rate differentials. Global hedge funds indulged in "yen-carry trades", which involved borrowing in yen, selling the yen for dollars, and investing the proceeds in relatively high-yielding US fixed income securities. This proved to be a very lucrative way of recycling Japanese current account surpluses to finance the US deficit, inasmuch as the Yen depreciated continuously between May 1995 and May 1997, which reduced the yen liability relative to the investment it financed.
 
Needless to say, such speculative foreign capital inflows have been crucial during the years of the American boom. One consequence of such flows has been steep asset-price inflation. Stock values, property prices and the values of other financial assets have risen sharply. This triggers a "wealth-effect" known to be strong in the US. Rapidly rising asset values which increases the wealth-holding of households encourages them to go out and spend triggering a boom. Add to this the effects of the large inflows of capital on liquidity in the system in the form of easy credit. The boom in consumer spending and housing starts fuelled by an easy credit and low interest rates situation strengthens the "wealth effect" and spurs the American boom based on money from economies which are ostensibly not doing well.
 
If past experience is any guide, an American boom should spur growth elsewhere in the world as well. Yet, as noted earlier, the phase of globalisation has been accompanied by remarkable unevenness in development across the developed countries. Among the many factors contributing to this unevenness is the American transition away from an era of budgetary deficits to surpluses. America’s post-War economic hegemony and the associated fact that the dollar was the world’s leading reserve currency ("as good as gold") had meant that the United States government faced no national budget constraint on its expenditures. It could print as much of the dollar as it wanted to and spend it anywhere in the world, where it was unquestioningly received.  In the past, the US government had used this advantage to finance large deficits, which helped sustain both US and world economic growth. By the mid 1990s, however, pressure to reduce the US budget deficit had begun to work. In the event, precisely during the years when capital was being sucked from across the globe to finance an American boom, and partly because of this way in which the boom has been sustained, a major change has occurred in the fiscal stance of the US State. The deficit of the United States government has been on the decline since financial year 1992 and turned into a budget surplus of around half of a percentage point relative to GDP in financial year 1998 (Chart 6). The surplus rose to 1 per cent in 1999.

The changed fiscal stance of the US has meant that a major stimulus to global growth has now been undermined. This explains the fact that through much of the 1990s there has been a loss of synchrony in the business cycles encountered by different advanced industrial nations. During the 1970s, the complacent view that industrial capitalism was finally rid of the business cycle had to be discarded. During those years and in the early 1980s, the contractionary responses to two oil shocks resulted in two major recessions across the industrial world. A noticeable feature of those recessions was their virtually synchronised occurrence in all the major industrialised countries.  However, matters seem to have changed considerably in recent times. While it is true that crises still remain an abiding feature of capitalism, a lack of synchrony in the phase of the business cycle in different countries appears to the principal feature of the current period.
 
The experience of Europe has been special, inasmuch as it had to face up to two compelling circumstances during these years: German unification and preparations for monetary union. This compelled government to hold expenditures firm. Since 1993 the fiscal deficit in EU has fallen continuously from 6 per cent of GDP to touch 1.1 per cent in 1999. Part of the reason was the need to keep the current account deficit from rising beyond a level that violated the conditions set for the realisation of monetary union. However, this involved a cost. Fluctuations in the fiscal deficit below the self-imposed ceiling obviously proved inadequate to prevent the steep and consistent rise in unemployment that the region has been witnessing.
 
As compared with the EU, Japan was not constrained by its current account at all, having notched up huge surpluses right through the 1990s. It was this factor that allowed Japan the freedom to experiment with periodic bouts of fiscal pump-priming, which took its fiscal deficit from 1.5 per cent of GDP in 1992 to 5.9 per cent in 1999. If despite this the strong recovery of 1996 in Japan was aborted, the reason lies in the currency crisis in East Asia and the inability of Japan to help moderate its consequences for output and trade growth in the region. Being far more dependent on East Asian markets than the US or Germany, the impact of the crisis on Japan has been sharp enough to stall the recovery the Japanese government had managed to engineer in 1996.
 
The Asian crisis did not matter as much to the US, since the transformation of the budget deficit into a surplus has been accompanied by a sharp rise in consumption expenditure. Given the large direct and indirect (through pension funds, for example) investments of personal savings in equity in the US, the stock market boom enhanced the wealth of American citizens, reducing incentives to save. The net result has been a sharp increase in private consumption expenditure and a collapse of private savings in the US. Personal savings as a percentage of disposable personal income in the US fell from 1.2 per cent in 1997 to 0.5 per cent in 1998, turned negative in the first quarter of 1999 and touched a remarkably high negative level of 1.3 per cent in the second quarter ending June 1999.
 
Most observers trace this low rate of savings, to the fact that the rising value of their financial assets, encouraged households to save less and borrow more, since they were convinced that the value of their past savings was more than adequate to finance their future requirements. Thus the role of financial asset inflation in sustaining high consumption was crucial. In 1997, household equity holdings were 143 per cent of disposable income in the US, up from an average of around 50 per cent in the early 1980s. It should be obvious that, in time, the consumption-led boom in the US would spill over into the world economy. That this has been occurring is clear from trends in the deficit in the trade in goods and services on the US balance of payments. That deficit has risen more than seven-fold from $37 billion in 1992 to $267.6 billion in 1999 (Chart 7). This magnitude of increase in the trade deficit accounts for almost 80 per cent of the increase in the current account deficit in the US balance of payments from $50.6 billion to $338.9 billion (Chart 8) during this period. This rising deficit did not matter for long, since capital inflows more than neutralised the effects such a deficit can have on the value of the dollar. Not only did money flow into US equity, but outstanding amounts of international debt securities originating in the US rose sharply to $946 billion at the end of the first quarter of 1999.

Unfortunately, the burgeoning deficit, which necessitates capital flows in the first place, could undermine confidence in the dollar. To boot, the recent speculative rush into US stock markets, led by unwarranted optimism regarding the future of "high technology" companies and their stocks, is now losing momentum. These developments have two implications. First there is a real danger that the one-way flow of money, which helped America flourish while other advanced nations languished or grew slowly would come to an end. This could aggravate the fall in stock markets currently led by disillusionment with hi-tech stocks. Second, the consumption boom led by the wealth effect could collapse. As the market decline wipes out illusory wealth, there could be an abrupt adjustment in the household savings rate from its current historic low which could massively squeeze consumption demand. This would mean that the only source of stimulus in the global economy today could be dampened, turning a process of slow growth into recession. The era of high growth and large current account deficits could come to an end. That prognosis is now a real possibility, though developed country governments and the international financial institutions are pinning their hope on a "soft-landing" in the US. Whatever the actual outcome, there is a strong possibility that the world may witness a return to an era of synchronised sluggishness or recession at its developed core. The confidence exuded at the top could thus be misleading complacence.