Macroeconomics: The world economy

mac·ro·ec·o·nom·ics (mak-roh-ek-uh-nom-iks) –noun (used with a singular verb)

“The branch of economics dealing with the broad and general aspects of an economy, as the relationship between the income and investments of a country as a whole. The part of economic theory that deals with national income, total employment, and total consumption.”

Macroeconomics is one of the most complicated and least understood branches of economics. Yet with the continuing, interconnected, globalization of the world’s economies, it is becoming one of the largest factors affecting investments world wide.

The “Rise of the Rest”

The “rise of the rest” is a remarkable achievement, bringing with it unprecedented improvements in living standards for the majority of people on the planet. But there is another, less happy, explanation for the rapid shift in the global centre of economic gravity: the lack of growth in the big rich economies of America, Western Europe and Japan.

Look at the world economy as a whole, and you could easily think that the recovery is in pretty decent shape. This week the IMF predicted that global GDP should expand by 4.8% this year—slower than in the boom before the financial crisis, but well above the world’s underlying speed limit of around 4%. Growth above trend is exactly what you would expect in a rebound from recession.

Yet this respectable average hides a series of problems. Most obviously, there is the gap between the vitality of the big emerging economies, some of which have been sprinting along at close to 10%, and the sluggishness of many of the rich countries from 0% to 2%. Research calculations from Harvard University and the National University of Singapore make the point starkly. They show that the average underlying annual growth rate of the G7 group of big rich economies between 1998 and 2008 was 2.1%. On current demographic trends, and assuming that productivity improves at the same rate as in the past ten years, that potential rate of growth will come down to 1.45% a year over the next ten years, its slowest pace since the second world war. A big difference from the sprinting 10%.

Are the “haves” and “have-nots” reversing?

Across the rich world the supply of workers is about to slow as the number of pensioners rises. In Western Europe the change will be especially marked. Over the coming decade the region’s working-age population, which until now has been rising slowly, will shrink by some -0.3% a year. In Japan, where the pool of potential workers is already shrinking, the pace of decline will more than double, to around -0.7% a year.

America’s demography is far more favorable, but the growth in its working-age population, at some 0.3% a year over the coming two decades, will be less than a third of the post-war average. With millions of workers unemployed, an impending slowdown in the labor supply might not seem much of a problem. But these demographic shifts set the boundaries for rich countries’ medium-term future, including their ability to service their public debt.

The Economist Magazine states that unless;

more immigrants are allowed in,
or a larger proportion of the working-age population joins the labor force,
or people retire later,
or their productivity accelerates, the ageing population will translate into permanently slower domestic growth.

Optimists point to America’s experience over the past century as evidence that recessions, even severe ones, need not do lasting damage. After every downturn the economy eventually bounced back so that for the period as a whole America’s underlying growth rate per person remained remarkably stable. Despite a lack of demand, America’s underlying productivity grew faster in the 1930s than in any other decade of the 20th century. Today’s high unemployment may also be preparing the ground for more efficient processes.

A world out of balance

In the emerging world the macroeconomic errors come from politicians behaving as if growth there were more fragile than it is. The pace has slowed a bit, but from breakneck speed to merely very fast. Most vital signs, from productivity to government debt, are healthy. Yet many policymakers are buying boatloads of dollars to stop their currencies rising as foreign capital pours in from Western investors seeking better returns. Emerging economies, as a group, still save more than they invest, which explains why global imbalances—notably the controversial surplus in China and deficit in America—remain so big.

Monsoon rains bring relief after the heat of summer but they can also cause flooding. A flood following a drought is a reasonable description of recent flows of private capital to emerging markets. During the worst of the crisis these flows collapsed, sending at least a few emerging economies into the arms of the IMF. Now, attracted by the developing world’s better growth prospects and exceptionally low interest rates in rich countries, money is surging back.

It is hard to know just how much cash is flowing in. Complete data on countries’ balance-of-payments positions are available only with a long time lag. An economist at Goldman Sachs has worked out a measure of net capital inflows from figures on countries’ foreign reserves and current-account balances. He reckons that flows into 20 big emerging countries are now running at a faster pace than before the crisis. According to his estimates, net capital inflows to these countries between April 2009 and June this year ran at an annualized pace of $575 billion, well in excess of average annual inflows of $481 billion in the two years prior to September 2008.

The economists note that the currencies of emerging Asian countries face the strongest upward pressure because of changes in the destination of private capital. As flows to Eastern Europe and Africa have shriveled, Asia’s share of the total flow of capital to the emerging world has gone from 61.3% in 2007 to 78.6% in the first half of 2010. Latin America’s share has also increased, from 15.2% to 20.9% over the same period. These are rising shares of a growing total, meaning that both regions are now getting more private capital than they were before the crisis. This effect is particularly strong for emerging Asia (see chart).

Upward Pressure for one Currency Means Downward Pressure for Another

Not every emerging country’s currency is under the same kind of upward pressure. India, for example, seems not to have intervened much in the foreign-exchange market, but its currency has not moved much over the past year either. Part of the reason is that capital inflows have gone mainly to finance its persistent current-account deficit. By controlling for this kind of thing the analysts find that Malaysia and Thailand have had the most “appreciation-friendly” regimes in Asia. Malaysia has largely been content to let its currency float upwards. The ringgit has risen by over 10% against the dollar since the beginning of the year. Malaysia’s reserve accumulation has been much smaller in 2010 than in 2006. South Korea, by contrast, has been absorbing virtually all of the upward pressure on the won by accumulating additional reserves. Peru is the country that has been trying the hardest to prevent its currency from rising. Interventions by Brazil look relatively modest once its size is taken into account. Colombia has pretty much allowed its currency to rise.

In the rich world the danger is the reverse. Big asset busts are usually followed by years of weakness as the over-borrowed repair their balance-sheets. Experience suggests that several years of slow growth lie ahead. Rich countries are planning tax rises and spending cuts worth 1.25% of their collective GDP in 2011, the biggest synchronized fiscal tightening on record. In many places a budgetary squeeze is necessary, but not all; and, taken as a whole, cutting this much this early is a risk. Even if demand remains strong enough to cope with this onslaught, the rich world’s longer-term growth prospects are darkening.

Ten years ago rich countries dominated the world economy, contributing around two-thirds of global GDP after allowing for differences in purchasing power. Since then that share has fallen to just over half. In another decade it could be down to 40%.

The bulk of global output will be produced in the emerging world. Europe’s working-age population is about to start declining; Japan’s is already doing so. Even in America the ageing of the baby-boomers points to a slower-growing workforce. In theory, faster productivity growth could offset this, but in most rich economies that was waning before the crisis hit—and the crash has clobbered productive potential. A feeble recovery could make matters worse, as the unemployed lose their skills, public debt builds up and firms put off investment.

A gaping growth gap between the emerging and rich worlds will, of course, shift economic might more quickly towards emerging economies. A fast-growing emerging world is fine, but a stagnating rich one serves nobody—especially if trade tensions start to rise. Western voters may find it intolerable that the likes of China still run big surpluses, thanks in part to those weak currencies. Protectionist rhetoric is already rising in the United States. The “have-nots” are beginning to “have”.

From the Macro to the Micro

The world would be better served by policies that both improve rich countries’ prospects and reorient growth in emerging economies. These should come in two parts. First, macroeconomic policies must be recalibrated. Emerging economies need to allow their currencies to rise more. The rich countries should tread carefully with fiscal consolidation: sensible budget repairs should be less about short-term deficit-slashing and more about lasting fiscal reforms, from raising pension ages to trimming health-care costs.

Second, and just as important, is microeconomic reform. There is a crucial missing ingredient just about everywhere in the world. The “micro” structural reform of each country, without which current growth rates are unlikely to last. The structural reform needed is different for each country, and sometimes the complete opposite.

Many emerging economies are slow to let their currencies rise to reflect their strength, even as the fragile rich economies are embarking on austerity programs. No matter what Congress threatens about the Yuan, China’s trade surplus will not disappear until it boosts investment in services, removes distortions that depress workers’ share of income and encourages households to save less. From telecoms to insurance, China is full of service oligopolies that need to be broken up.

Similar growth tonics need to be applied in much of the rich world, both to boost domestic spending in surplus economies, such as Germany and Japan, and to raise productivity. America is more productive than the euro zone and Japan largely because the latter both have a lousy record in services (too many rules and not enough competition). Many labor markets also need an overhaul, especially in southern Europe, where it is still far too difficult to adjust wages or fire permanent workers. One advantage of the crisis for Spain and Greece is that they have been forced to make a start on this.

The United States also has its own microeconomic to-do list, albeit of a different sort. The most urgent item is the festering mass of underwater mortgages. Almost 25% of homeowners with mortgages owe more than their houses are worth. Faster, more thorough debt restructuring is needed, to make it easier for workers to move to where jobs are more plentiful and to hasten financial recovery. Schemes for unemployment insurance and training also need attention, so that high joblessness does not become entrenched.

None of these structural reforms is easy. Peer pressure could help. Rather than being fixated on harsher budget-deficit rules, the European Union’s members should pledge to complete the single market in services, to open up cozy national markets to greater competition. The members of the G20 big economies could commit themselves to specific structural goals, from raising retirement ages to deregulating things like transportation. A bold microeconomic agenda will not yield instant rewards. Nor is it a substitute for getting the macroeconomics right. But without it, global growth will eventually falter.

Faster growth is not a silver bullet. It will not eliminate the need to trim back unrealistic promises to pensioners; no rich country can simply grow its way out of looming pension and health-care commitments. Nor will it stop the relentless shift of economic gravity to the emerging world. It is unavoidable. Since developing economies are more populous than rich ones, they will inevitably come to dominate the world economy. (China has already overtaken Japan as the world’s second largest economy.) But whether this shift takes place against a background of prosperity, or stagnation, depends on the pace of growth in the rich countries. For the moment, unfortunately, too many rich countries seem to be headed for stagnation.

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