Global view yields different results

This is my latest Perspective column for Fund Strategy magazine.

Sometimes, the conventional assumptions used to examine economic problems are misleading. A different approach would lead to radically different conclusions.

Take the economic plight currently plaguing the developed world. One key convention is to look at domestic economies first before modifying the analysis to take into account international factors. Another mainstay of the orthodoxy is to focus on the relatively short term; perhaps the last few years at most.

Andrew Smithers, one of the City’s most perceptive commentators, has overturned both assumptions in a revealing new study.* It makes a strong case that the world is entering a new, and in many respects more difficult, economic era. The subtitle, Sauve qui Peut (which can be translated as “every man for himself” or “stampede”), hints at his pessimistic conclusions.

America, still the world’s largest economy, provides the best example of the insights that can be gleaned by following Smithers’ approach. There is a voluminous debate about the appropriate scale of America’s fiscal stimulus but little of it takes into account the consequences of its changed international position.

For a start the American economy is much more internationalised than it was in the immediate aftermath of the second world war. Its international trade is equivalent to 31% of GDP compared with 7% in 1950.

That means that a substantial portion of any American stimulus will bolster economic output outside of America. From a domestic policy perspective it is “leaking” to the rest of the world.

The same is true of Japan and Britain although in absolute terms both economies are much smaller than America. A significant proportion of any domestic stimulus will buoy global rather than domestic demand.

At the same time as America is becoming more internationalised it is also becoming less influential. It represents only 17% of global output compared with 27% in 1950. America is therefore both more prone to external influences and less able to steer the global economy.

The other side of this story is the huge rise in the relative weight of the emerging economies; particularly since 1990. As America and Britain have declined in importance these countries have moved towards filling the gap.

This trend was not apparent in the period immediately following the second world war. From 1950-1970 the developed world’s GDP grew at an average rate of 4.8% per year while output in the emerging economies grew at 5.0%. In other words the gap between the two in terms of relative economic weights remained roughly stable. At the same time the gap in living standards was still widening as GDP per head continued to rise faster in the developed world (with its population growing more slowly).

The situation began to reverse from 1970-1990 but in the most recent period a dramatic shift has occurred. GDP in the emerging economies grew at an average rate of 5.0% per year compared with 2.0% for the developed world (see table).

This shift constitutes an enormous change in global economic weight. Emerging economies represent 62% of the world economy compared with 24% in 1950. If the growth rates of the past 20 years continue for the next 20 the emerging world will constitute 75% of global output.

Smithers concludes from these global shifts that calls for western countries to continue with fiscal stimulus are unlikely to work. He gave the recent “manifesto for economic sense” by Paul Krugman and Richard Layard in the Financial Times (June 27) as an example. America, Britain and Japan cannot afford to continue to run large deficits while Germany is unwilling to do so.

In any case maintaining fiscal stimulus would simply encourage the rest of the world to continue with unsustainable policies. The key problem is that emerging economies are artificially bolstering their exchange rates through currency intervention.

If developed world currencies were allowed to fall it should bolster their exports to the emerging world. Indeed Smithers goes further and argues that western countries should deliberately depress their exchange rates just as emerging economies have until now.

This is where the idea of “every man for himself” comes from. Each country would more aggressively pursue its own narrow national interest.

Smithers also advocates policy measures to be taken within the developed countries. He argues that the bonus culture in America and Britain needs to be reformed as it diverts resources away from business investment. For Japan he advocates tax reform to counter the perverse incentives created by generous depreciation allowances.

These measures are all likely to be necessary for some time. Smithers argues, with considerable justification, that the world economy has changed so policy needs to shift accordingly. Too many policy-makers are still living in the old world that immediately followed the second world war.

Smithers’ approach produces valuable insights but it is itself vulnerable to a critique of its assumptions. It relies heavily on accounting identities where a change in one country or sector has to be offset by a corresponding change somewhere else.

For example, GDP is equal to the sum of consumption, investment, government purchases and net exports. Therefore, everything else being equal, a fall in consumption must, by definition, be accompanied by a corresponding rise in investment.

Such equations are central to conventional economics but they are of limited use. They give a snapshot of imbalances at a particular time but they can also distract attention away from the importance of the real economy.

The challenge facing America, for instance, is not simply about bringing it back into balance with the global economy. At the most fundamental level it is about bolstering the real economy and promoting new rounds of investment. The economic orthodoxy gives little attention to such challenges.

^{* The End of the Post-war Era – Sauve qui Peut. Smithers & Co. Report number 404. July 9, 2012.}