New Tremors in Global Finance and Trade

Recovery from deep recessions is usually strong – the American economy recovered from the two other deep post-World War II recessions with annual real growth over 6% for three years. But nobody forecasts strong growth like that now, because recoveries from financial crises are usually slow and painful.

It is worth remembering the real dimensions of the 1930’s Great Depression, with which politicians compare this recession to justify massive government intervention. From 1929 to 1933, real GDP in the United States fell 30%, and the unemployment rate reached almost 25%, while the depression itself lasted more than a decade – all large multiples of the recent decline, and of the somewhat larger decline that the intervention helped to avert. 

Policy mistakes ranging from tax hikes to poor central-bank decisions to a global wave of protectionism (most famously America’s Smoot-Hawley tariff) turned a deep recession into the Great Depression. We should not repeat those mistakes now.

While global leaders expand IMF resources and attempt to coordinate international financial regulation, trade and currency tensions are growing. French President Nicolas Sarkozy and Chinese Premier Wen Jiabao chastise American protectionism. Meanwhile, there has been virtually no progress in restarting the Doha round of global trade reforms. When progress is not being made, non-tariff barriers grow like weeds in response to domestic interests.

Tensions are rising over currencies as well. Given the expansion of the US Federal Reserve’s balance sheet, its purchase of long-term Treasuries, the Fed’s historical record of being late and slow in raising interest rates, and the explosion of US public debt, there is fear of an eventual monetization of the US debt and future inflation.

Today, there is little short-run inflation risk in the advanced economies; core inflation will decline, both in the euro zone and in America, and Japan’s problem will be deflation.   But inflation is a risk in some emerging economies, including India and China, whose central bank governor, Zhou Xiaochuan, suggests considering a basket of currencies to replace the dollar as the global reserve currency.

Conversely, US President Barack Obama promises to “get tough on China’s currency,” and America’s Congress is considering a move to force the US Treasury to label China a currency manipulator, paving the way for retaliatory tariffs. But China’s trade surplus with the US is not primarily due to undervaluing its currency. 

The tremendous growth in global current-account imbalances magnified problems that led to the financial crisis. Indeed, the surplus in developing Asia, Japan, and the Middle East soared from less than $200 billion in 2001 to more than $1 trillion in 2008, while the deficit of the US and the European Union rose from $425 billion to more than $900 billion. So the last thing the global economy needs now is a trade war.

Not only has the euro gyrated recently, but some now question its long-term viability. On balance, the euro has been a success, but it does balance gains from price transparency and decreased transaction costs against the loss of independent monetary policies and a currency adjustment shock absorber.

With no separate currencies to adjust, the only shock absorber left is labor migration to areas with lower unemployment – for example, from southern to northern Europe. Such migration is easier in the US than within the euro-zone or even within European countries. Thus, countries on the EU’s periphery – Portugal, Italy, Greece, and Spain – with large public debt and current-account deficits, face lower real wages and high unemployment for some time.

The greatest systemic risk to the global economy, far greater than that associated with any financial institution, is the explosion of public debt. The IMF forecasts the debt-to-GDP ratio in the US to rise to 85% by 2014 (prompting the rating agency Moody’s to threaten a downgrade in America’s bond ratings), and to 82% in Germany, 85% in France, 126% in Italy, and 144% in Japan.

As recovery continues, this public-sector debt will increasingly crowd out private-sector, local-government and developing-country borrowing. Uncertainty over the resolution of the debt is likely to provoke political instability over tax hikes and spending cuts, and therefore volatility in financial markets.

Worse still, high levels of public debt, like high taxes, cause serious problems for economic performance. The IMF estimates that every increase of ten percentage points in the debt-to-GDP ratio reduces long-term growth by a quarter of a percentage point. In other words, the projected increase in debt ratios could slow long-term annual growth by 0.6 percentage points in the euro zone, almost one percentage point in the US, more than one percentage point in the United Kingdom, and 1.3 percentage points in Japan.

Cutting growth rates by 40-70% is surely a recipe for stagnant societies with insufficient growth to satisfy private wants and public needs. Moreover, such a slowdown would devastate the developing world, as weaker performance in the advanced economies reduces the growth of export markets.

These tremors in the international financial system are serious and must be contained. A long period of sluggish growth as a result of bloated government debt would be the equivalent of an extended bout with cancer after the heart attack that our economies have just survived.   Prevention begins by curbing trade friction and developing sensible post-crisis monetary and fiscal exit strategies, sooner rather than later.

The author is a former Chairman of the US President’s Council of Economic Advisors, is Professor of Economics at Stanford University and a senior fellow at the Hoover Institution.
© Project Syndicate 1995–2010