Thursday, March 26, 2009

Yet another paradox of thrift

The most recent IMF projections for the world economy indicate that in 2009 we will see world output contracting for the first time in the last thirty years. The global nature of the crisis has come as a surprise to some. A few years ago as we witnessed an increasing divergence of growth rates between advanced and emerging economies (see chart below) there was much talk about the “decoupling theory”. While for many decades advanced economies and emerging markets had displayed very similar growth rates, after the mid-90s, partly driven by the fast growth rates of the largest emerging countries, there was an increasing gap between the two.  It was this increasing gap that led to the "decoupling theory" and the assumption that a slowdown in advanced economies would not affect emerging markets.

Why is this recession global? Why is it that problems originating in some (not even all) of the advanced economies that were on a path of unsustainable spending, current account deficits and asset price bubbles has spread everywhere? How can it be that countries that prior to the crisis had a current account surplus, limited appreciation in asset prices, no subprime mortgages are also being dragged into a recession?

The global nature of the current recession is clearly a consequence of the increases in trade and capital flows that we had witnessed in previous decades. But, more importantly, it is also a reminder that imbalances (such as current account imbalances) always have two sides. When adjustments are needed they require changes not only in countries with deficits but also in those with surpluses. In fact, under some circumstances, the changes can be as dramatic for those who were seen as the cause of the problem (the countries with a deficit) than for those who seemed to be doing everything right.

Here is the intuition: Let’s split the world into countries with current account deficits (the ”spenders” (US)) and countries with current account surpluses (the “producers” (Germany, Japan, China)). The countries with deficits were, of course, financing their excess spending by borrowing from those who had a surplus. At some point, the countries with a deficit realize that they are not as rich as they thought and they are forced to cut their spending. They were the ones with a problem, with an imbalance to solve but what happens to the “producers”?Clearly they will see the demand falling for their products (their exports). What is interesting is that, under some circumstances, they might see a drop in GDP which is as large as the countries that “were in trouble”. In fact, and what might look like a contradiction, it is likely that the larger the initial imbalance, the more the countries with a surplus will suffer, in terms of GDP (think about an extreme case where the spending countries do not produce anything, all the fall in GDP will happen in the producing countries). So for the countries with large current account surpluses, their apparent position of strength before the crisis has turned against them when the crisis takes place and they might see larger drops in GDP than the countries that started with a deficit.  In addition, if their exports were in goods that are highly cyclical (durable goods, cars, equipment, IT), the effect can be even more dramatic, and this is an important factor for Japan, Germany or some of the Asian exporters. Finally, how much of the necessary adjustment of spending in the US will fall on imports versus domestic goods will be a function of the exchange rate.

Let me be clear that this does not mean that the countries that started with a deficit are not suffering the consequences of the crisis, what I am looking at here is the evolution of GDP, a measure of production. What we have is a very different pattern of adjustment when it comes to spending or consumption. In a country like the US we have consumption falling at a rate similar to GDP while in countries like Germany or Japan, consumption is not falling that much. So if we take the perspective of consumers we can say that consumers in Germany or Japan are not feeling the pain of the recession as much as the Americans. But when we look at GPD and because of the collapse of their exports, German of Japanese GDP are expected to contract at a similar or even faster pace than in the US (the most recent IMF forecasts for 2009 are -5.8% for Japan, -3.2 for the Euro area and -2.6% for the US).

In summary, generating current account surpluses and accumulating reserves as protection against the possibility of a future crisis cannot be seen as a a guarantee against a global recession, especially if it is caused by the need to adjust global imbalances. The accumulated savings will serve as a buffer to avoid a fall in domestic spending but we might still see a significant slowdown in GDP growth or even a recession. 

Antonio Fatás

on March 26, 2009 |   Edit