Hold the Champagne Uri Dadush International Economic Bulletin, April 2009

Carnegie Endowment for International Peace

Hold the Champagne
Uri Dadush International Economic Bulletin, April 2009

Data suggesting that the freefall in world activity may be moderating have sparked a five-week global stock market rally. Major economic policy announcements in the United States, Japan, and at the G20 summit in London have raised expectations that the start of recovery may be near. But it is far too soon to uncork the champagne. Not only is recovery uncertain, but the possibility of a deepening and more protracted downturn remains. For the time being, large job losses continue and the violence of the global financial crisis remains untamed.

In this financial crisis, as in previous ones, the path of demand depends on how income growth affects asset prices and balance sheets, and how these, in turn, affect demand and incomes. Virtuous or vicious cycles can result.

Policy now plays a crucial role in determining whether we converge toward a low or high equilibrium. Of all possible outcomes, a recovery late this year or early in 2010 may be the most likely, and this is what we hope. However, in these highly uncertain times, even an optimist must recognize the consequences of an unabated downturn. Policy makers ought to recognize these potential losses as well, and strive to do more to counteract the crisis.

Strong Downward Momentum of Economic Activity
The OECD estimates that world trade has declined at an annual rate of 20 percent in the first quarter of 2009, the same rate by which it declined in the fourth quarter of last year. Global GDP is estimated to be declining currently at a 4.3 percent annual rate. For the year as a whole, world GDP is expected to decline by 3 percent, a worse decline than seen in any other postwar period. Core inflation in the industrial countries is expected to remain near zero this year and may tip into deflation, while inflation will continue to decline rapidly in developing countries. The decline in global industrial production and trade since the crisis began is unprecedented, worse than even the Great Depression, as Figures 1 and 2 describe.

Figure 1. World Industrial Output: the Financial Crisis vs. the Great Depression

Source: Eichengreen and O’Rourke (2009)

Figure 2. The Volume of World Trade, the Financial Crisis vs. the Great Depression

Source: Eichengreen and O’Rourke (2009)

Fortunately, financial rescue plans and the response of monetary and fiscal policies have so far avoided the mistakes that greatly contributed to that catastrophe (Eichengreen and O’Rourke 2009). Further, there are tentative indications recently that the freefall in activity may be slowing. Surveys of purchasing managers, which have proven reliable leading indicators in the past, indicate that while activity in most industrial countries is expected to continue declining, the balance of positive answers to negative answers is improving.

February exports in the four largest trading nations—Germany, the United States, China, and Japan—are down 20–50 percent from the same month last year, but have improved or fallen less rapidly compared to exports in January. Retail sales in the United States and China in February were up on the previous month. China’s directives to banks appear to be working to boost lending, and, together with fiscal stimulus, are reflected in increased car sales and higher fixed asset investment. (See later section for a fuller account of recent developments in China.)

Looking forward, the need to rebuild depleted inventories suggests that production will need to grow more rapidly than demand (or decline less rapidly than demand) in coming months.

However, it remains unclear whether these modest and scattered signs of improvement are the harbingers of a bottoming out, or whether they indicate that, following the financial shocks of last September and the collapse of activity that ensued, the world economy is now settling into a more moderate path of protracted decline. As Figures 1 and 2 demonstrate, even during times of depression, an economy can experience short upticks. Only longer-term, more stable upward trends can demonstrate that we are on the path to recovery.

Today’s global downturn will end, as have others past, when the natural self-correction in the markets for housing, cars, and other consumer durables occurs, and when this is reflected in a turnaround in investment across a broad spectrum of countries.

Countries are at different phases of the cycle, and the United States, having been first into this crisis may be among the first out. The demand for homes and consumer durables is more likely to recover the longer pent-up demand accumulates, prices fall, interest rates decline, and the banks become more willing to lend. With the exception of bank lending, all these factors are currently working in the right direction, but the signs of a turnaround in the demand for durables remain weak. The relentless rise in unemployment deters households from undertaking new spending commitments that will further strain their balance sheets, and banks are reluctant to lend for the same reason.

Balance Sheets are Badly Impaired
The significance of the effect of impaired balance sheets on activity has been brought out by several recent studies.

One of the most pertinent to today’s situation is a review by Barro and Ursua of the incidence of economic depressions since 1890. They define a depression as a 10 percent peak-to-trough decline in GDP. By comparison, U.S. GDP may have fallen by 3 percent since its peak in the second quarter of 2008. Barro and Ursua identify 84 cases of countries falling into depression and conclude that a stock market decline of 25 percent or more is associated with a 20 percent chance of depression occurring. Since this crisis began, stock markets around the world have declined by about twice that amount. Furthermore, an examination of their data reveals that almost 90 percent of depressions occurred during a world trade contraction, such as we are experiencing today.

Another study has estimated that today’s fall in housing and stock prices have reduced wealth in the United States by about 100 percent of GDP (Pomerleano, Scheule, and Scheng in VoxEU.org). While the effects of falling house prices may be less than usually assumed (most houses are owned by people who need to live in them), these large declines in asset values sharply reduce borrowing capacity and boost savings rates.

Banks have suffered the biggest deterioration of balance sheets. Various estimates of bank losses (e.g., IMF 2008) suggest that the deterioration of U.S. originating asset values on the books of banks exceed $2 trillion, a sum about 50 percent larger than the capital base of U.S. banks at the start of the crisis.

These calculations do not include the effect of increased expected future tax liabilities that households and firms can expect to incur to fund increased government deficits and bail-outs.

The balance sheets of governments have also been weakened. Judging by rising yields on government bonds, several high-income countries, including Italy, Ireland, Greece, and Portugal, are already testing the limits of prudent borrowing. Though yields on Japanese government bonds have declined, debt/GDP ratios may approach 200 percent before this crisis is over. According to Reinhart and Rokoff (2008), financial crises are associated with a 70 percent increase in the public debt/GDP ratios on average, and recent IMF projections suggest that we may be tracking the historical record.

The deterioration of balance sheets is an important factor accounting for the fact that the growth decline associated with financial crises lasts 2 to 3 times longer than ordinary recessions, and the peak-to-trough decline in output is 2 to 10 times larger (Reinhart and Rokoff, 2008).

However, even as activity continues to decline, recent news has offered some hope that the fall in asset prices may be slowing or be reversed. Policy announcements, including Japanese fiscal stimulus, the U.S. bank rescue scheme, and IMF recapitalization, have helped boost investor confidence.

While there is little sign so far that housing prices have stopped falling, a remarkable rally in stock markets has seen equity prices rise for five weeks in a row. Stock prices have risen 20 percent in the industrial countries and about 35 percent in emerging markets. The yield on non-investment grade bonds has fallen sharply. These developments help rebuild capital values and reduce borrowing cost.

In the United States, there are signs that banks may be returning to profitability, helped by capital and liquidity injections and lower policy interest rates, which have contributed to a widening interest margin—lower funding costs relative to interest rates charged on loans. Banks worldwide are charging less to lend to each other, an important sign of improved confidence and loosening credit conditions.

These positive developments may or may not prove to be sustained. We simply do not know. What is certain, however, is that the rebuilding of impaired balance sheets will not happen overnight, and that, even if we are at a turning point, the process of recovery will be difficult and protracted.

Emerging Markets
Some emerging markets may provide modest support to global recovery but others present an additional source of risk. Even though emerging markets have been severely affected by the crisis, they can play an independent role in its resolution. This role can be positive or negative, depending on country circumstances.

A group of countries amounting to some 13 percent of world GDP, including China, India, the reserve-rich Gulf countries, and several others, are likely to be the only ones to see growth in 2009 and thus provide some modest support to world aggregate demand growth. But even if all these countries grew at 8 percent (China’s official target) in 2009, the total addition to world aggregate demand would still be less than 1 percent, while industrial countries (which represent about 70 percent of world GDP) are subtracting about 3 percent.

However, the fact that the financial sector in the group of growing developing countries has remained relatively robust provides some assurance that their growth can be sustained, albeit at much lower levels. These countries can also return relatively quickly to a high growth path once world demand picks up.

On the negative side, another large group of countries amounting to some 6 percent of world GDP, including Russia, several Eastern European nations, and a few countries in Latin America and Africa, are highly vulnerable to the crisis continuing. Several may run out of reserves or suffer even larger currency devaluations and an outright collapse of their financial system, as well as sovereign default. This, in turn, will have repercussions on other countries, and most significantly on European banks with large exposure to those regions.

The recent G20 decision to recapitalize the IMF and to issue new reserve money in the form of SDRs provides some comfort that shocks from this source can be mitigated, provided these decisions are implemented quickly.

Policy Can Do More
Discretionary fiscal measures, excluding the working of automatic stabilizers such as increased unemployment insurance, may add less than 1 percent of GDP to demand in the high-income countries over the next twelve months according to the OECD. The effect of lower policy interest rates, liquidity injections and asset purchases by central banks (quantitative easing) will provide additional demand stimulus, but is difficult to quantify their impact, given the propensity of banks, firms and households to hoard cash. All these measures combined will provide support. But they are not sufficient to offset the decline in demand coming from consumption and investment and exports. In the case of the United States, for example, the total demand decline may subtract as much as 5 percent of GDP in 2009.

The G20 summit took important steps to strengthen the International Financial Institutions and also gave the WTO a clearer mandate to identify protectionist measures. But the G20 was a disappointment in committing to more concerted and aggressive actions on three fronts: fiscal stimulus, where several European countries with moderate debt/GDP ratios could do more; quantitative easing, which the European Central Bank has promised to consider but has done little about; and restructuring banks, where progress in the United States has been slow and erratic.

Action on all these fronts is needed now, as is vigorous execution of the stimulus and financial rescue measures already planned. Hold the champagne for New Year’s Eve!