Andy Xie (the economist who got into trouble with Singapore government) is still one of the top economists in Asia by any measure. Pleasantly surprised with his discerning views and solutions on the current global crisis. Good piece.
By Andy Xie, Caijing guest economist and board member of Rosetta Stone Advisors Limited
From Caijing Magazine
Policymakers around the world have not shown an understanding of the current crisis. It is the end of a two-decade long bubble. It is the end of the asset-based economy. It is the end of productivity dividends from IT revolution and globalization. Perhaps one tenth of the income in the global economy was from bubble activities and is permanently lost. The income will shift elsewhere. The resulting demand is different. The supply side has to change to meet a different mix of demand in the post bubble economy. If governments don’t understand, the world may suffer a lost decade ahead. No, it is not
Stock markets around the world have fallen close to or below the lows of November 2008. Concerns over bank bailout uncertainty and deepening recession drove the decline that reversed the 20 percent bounce from the lows of November 2008. The delays in releasing details by the U.S. Treasury on its bank bailout plan led to suspicions that it didn’t know what to do yet. The exposure of European banks to
On the economic front, the news is grim:
Three forces are behind this. First, the collapse of Lehman Brothers triggered a sharp increase in credit cost. Its impact was similar to increasing interest rate by 3 to 5 percent by all the central banks together. To cope with high cost of capital every business has been running down inventory, which is the cheapest way to raise funds. In commodity industries, inventory unwinding has been dramatic. Most commodity users kept inventories high for fear of price increase and speculation. When commodity prices reversed, they were stuck with a depreciating asset and had to run it down as quickly as possible. I suspect that this force accounts for half of the economic contraction at present.
Second, faced with rising credit cost and declining demand, businesses around the world have cut their capital expenditure (capex) sharply. This force is most visible in the IT sector.
Lastly and the most obvious, the negative wealth effect from the evaporation of US$ 50 trillion paper wealth is cutting into consumption. The rule of thumb suggests that the negative wealth effect is about 5 percent. As two thirds of the global economy is consumption, ceteris paribus, the global economy can contract by 3 percent just due to this effect. Its impact is not all felt yet. Most consumers will adjust slowly.
The inventory cycle and reduced capex are temporary factors pulling down the global economy. At some point, inventories are sold, and capex is too low to cut. I suspect that inventory destocking will be completed in the first quarter of 2009, and that capex stabilizes in the third quarter. The global economy will probably show stability then. As fiscal stimulus kicks in around the word, we may see a significant bounce in the global economy in the second half of 2009. But stability or a stimulus-inspired bounce won’t lead to a sustainable recovery. Consumption weakness will haunt the global economy for a long time. The over-leveraged western consumer needs to pay down debt for years to come. Rising unemployment will make the problem worse. The western consumer – the driving force behind the global economy for the past decade – is down and out for good.
Governments must understand the lasting nature of the current downturn. The bursting of the credit bubble triggered the fall. The mismatch between income and demand could delay a sustainable recovery for years. During the bubble era income distribution became more and more skewered towards asset-based activities. For example, the profit share of financial activities among U.S.-listed companies quadrupled. Similar trends happened in many countries. The income for the workers in finance increased in a similar fashion. The bulging income from the financial sector was quite concentrated among a small group that spent money in luxuries and financial investment. This is the most important factor for rising concentration of income distribution around the world in the past decade.
The bursting of the bubble will destroy most income in financial activities. The amount lost could be one tenth of GDP. From limo drivers to luxury homebuilders, the compounding effect from the financial meltdown will leave unemployment across many industries and countries. The recovery becomes sustainable only when supply side is restructured to cater to a different demand mix. This process could take a long time to complete. But governments might prolong the downturn by making the wrong decisions. For example, governments around the world are engaging in fiscal stimulus. To some extent they are choosing winners, but if the ventures they back are way off what market would support, the stimulus would delay recovery. Stimulus is necessary in a severe downturn like now. It just needs to match the structural changes to come.
Let us think through the problem facing an unemployed banker and his ex-driver. The banker could splurge and hire a driver since he was making 20 times his driver’s wage. Of course, in addition, he was paying for his florist, tailor, maid, masseur, etc. On average, he spent 70 percent of his income on the equivalent of 15 people like his driver full time serving him and put 30 percent back in financial investment like in a hedge fund. Now, the ex-banker moves to
The banker’s income before came from asset market activities, essentially redistributing income to himself by manipulating asset prices. As he stops doing that, the cost for economic activities goes down by the amount equal to his income. But the people serving him have lost their income. The net result is that the economy contracts by the same amount as the banker’s income plus 15 unemployed people. In addition, the 15 unemployed people can’t spend. The multiplier effect magnifies the banker’s income contraction, possibly by a factor of two. The world looks worse off with a smaller economy and more unemployed.
When the government steps in to stimulate, it is essentially borrowing the equivalent of banker’s ex-income to spend. The purpose is to keep the 15 people employed. However, the government won’t spend on drivers, nannies or florists. The mismatch means the government can’t get the economy back with stimulus. It shouldn’t. The driver must find new customers. The banker is gone for good. What the government should try to do is stop the multiplier effect from the 15 people that the banker no longer hires. If these 15 people get unemployment, it could go a long way to mitigate the multiplier effect. The economy can come back when it is restructured so that the 15 people find new employment.
The world will eventually be better off. The banker was just redistributing income to himself. The money would lead to more productivity if it could be directed to more productive people. It’s just that the process of adjustment could be long. The world has experienced an asset-based economy for two decades. It has led to extreme income distribution. In the last few years, large manufacturing companies like GE and GM came to depend on financial activities for profits. Their industrial activities were really used as a fund raising platform. In
While we need to worry about the long-term effectiveness of stimulus spending, the short-term effectiveness is not yet secure. With global banks still mired in toxic assets, they won’t be able to lend normally. If stimulus pushes up economic activities, businesses that want to invest to meet new demand may not get loans. In an upward virtuous cycle, rising demand leads to investment that leads to more jobs and more demand. Without a functioning banking system, this virtuous cycle is not possible. Instead, stimulus just perks up the economy temporarily.
The immediate task is to repair the banking system, especially in the
The right approach is to nationalize these banks, separate the toxic assets into a different entity, and relist the healthy halves. The proceeds from selling down the healthy banks could be used to pay for absorbing the losses from disposing toxic assets. This is what
Second, the West must contain the cost of its entitlement programs, beginning with healthcare in the
The biggest economic challenge among developed economies is aging, which leads to escalating pension cost and exponentially rising healthcare cost. While the wrong policies allowed the credit bubble to happen, the desire to defend an old lifestyle while social overhead grows higher was a major contributing factor. It allowed the western economies to delay the hard choices. The current system was set when aging was not a big challenge. The only viable course forward is to increase the retirement age and ration healthcare access.
Third, emerging economies must decrease export dependency. Export-led development usually reflects weaknesses in the political economy – the inability to efficiently turn savings into investment. The causes are usually lack of the rule of law and income and wealth concentration. Export orientation is to import the global system. From
The problem with the model today is that it is crowded. Developing economies are already 30 percent of the global economy at current price and nearly half on a purchasing power basis. The export model cannot thrive for shortage of customers. Developing countries have to trade more with each other and develop domestic demand. But this would require painful reforms to their political economies. The key is property rights and income distribution. The two must go hand in hand. Lack of domestic demand tends to result from income concentration, which is due to uneven playing field in opportunities. Many developing countries, like South American and Southeast Asian countries, have stagnated in the past decade due to their inability to reform their political economies.
Bursting of the credit bubble is triggering the biggest recession since the World War II. Repairing the global economy requires complex and difficult reforms. Simple stimulus can’t bring back prosperity. While stock markets may improve in the second and third quarter, it is merely a bear market rally. When inflation concerns hit the market towards the end of 2009, stock markets could fall sharply again. Indeed, the ultimate bottom in the current cycle could happen in 2010.
p/s photos: Meisa Kuroki