Financial Times chief economics commentator calls for investment as the way out of the crisis – by Michael Burke

In recent articles in the Financial Times, that paper's chief economics commentator Martin Wolf has increasingly acknowledged that investment will be decisive in engineering an economic recovery, especially for highly-indebted countries, such as Britain. [1] He also argues that conventional wisdom about the prospects for economic recovery, and the policy adjustments that will be necessary, is wrong. 'The conventional wisdom is that it will also be possible to manage a smooth exit. Nothing seems less likely.'

The reason for his sober assessment is the trend in private sector financial balances; that is, the growing surpluses of private sector incomes over private sector expenditures. For the OECD as a whole this surplus of private sector savings is projected to reach 7.4% of GDP this year. Britain is one of six countries that will run such financial surpluses of more than 10% of GDP.

This situation, as Wolf points out, has been dubbed 'the paradox of debt' by Paul Krugman, following the Keynesian notion of the 'paradox of thrift'. The argument is that, while for each highly-indebted company or individual it makes sense to save, or in the current climate pay down debt, for the economy as a whole it is potentially disastrous. The aggregate saving reduces final demand, both for business investment and household consumption, and thereby deepens the recession. So incomes for individuals and companies falls further, and they respond by cutting expenditures further, and so on.

There are many criticisms of this notion from what has become orthodoxy over the past several years. The only serious one is that, if the private sector saves in this way but continues to consume and invest in the same proportions all that will then happen is that prices will fall, and goods and services will be cheaper at the new, lower level of spending. However, this ignores two trends that tend to occur in crises and are happening currently, most especially in Britain.

The first is that in a recession investment falls much faster than consumption. Private investment is controlled in the first place by profitability and not by the objective need for production of society. Furthermore, both individuals and companies cut back on investment in order to maintain vital consumption.

Of a total decline in Britain's GDP of £80bn, personal consumption has fallen by £29.5bn and fixed investment has fallen by £45.9bn. In fact, the fall in investment accounts for a little under 60% of the aggregate decline in GDP. This is shown in Figure 1.

Figure 1

The same pattern, whereby investment is the main driver of the recession, is replicated across the OECD. It is simply not the case that consumption and investment fall in equal proportions. Household consumption has fallen by 3.6%, compared to a fall in fixed investment of 19.3%. Investment is still falling, whereas all the other key components of GDP experienced small rises in the last quarter of 2009.

The second reason why this orthodox criticism is invalid is the level of debt. If prices fall, as orthodoxy expects, the real level of the debt only increases - as has happened in Japan since the beginning of the 1990s deflation in that country. In Britain there was a real danger of deflation, that is persistent price falls, at the end of 2008 and beginning of 2009, which has been averted by lower interest rates and a weaker pound. But a return to falling prices would mean increases in the debt-servicing burden for all income earners in Britain, including individuals, corporates and the government.

Martin Wolf argues that, while extremely loose monetary policy has been necessary, simply by itself it stores up two alternative problems, both of which lead ultimately to potential disaster. One possibility is that cheap money reignites a boom in consumption, which itself merely postpones an even bigger future financial crisis. The other possibility is that there is no recovery in consumption and the fiscal position deteriorates further, to the point of widespread government defaults.

His solution, set out more fully in the second article 'How unruly economists can agree', is that investment is the solution to both the economic slump and the crisis in government finances. 'What governments should do, instead, is ensure that deficits are credibly temporary, and growth-promoting. By all means, plan to cut the structural deficit faster than the government now intends. But do not believe that that would be the end of the matter. The actual deficit might need to be larger than that, for a long time. Try investment, instead'.

Who will invest?

This focus on investment is the correct one. But Martin Wolf's reliance on the private sector, and cutting the government deficit, is misplaced.

As we have already seen, it is the huge investment fall which is driving the recession. Only a very large increase in investment can therefore restore both prior levels of activity and government finances. Martin Wolf correctly chides many private sector economists and policymakers for wishing the world would return to the way it was before the crisis. He dismisses that hope as both misguided and forlorn. Yet his own hopes for a return to private sector investment themselves are seriously inadequate.

Many private sector economists expressed shock at the very recent data showing that the collapse in UK business investment continues unabated They shouldn't be surprised. Business fixed investment fell by 5.8% in the final quarter of 2009, down 27% from its peak in early 2008. The annualised fall is £40bn, over half the fall in GDP. Manufacturing investment is down 37.5% from its peak, construction down 54.3%, engineering and vehicles down 37.8%, transport down 29.8%.

This litany of an investment collapse, a literal investment strike, highlights a key problem for the idea that encouraging the private sector to invest will provide a sufficient answer to the crisis. Martin Wolf's proposals are private investment incentives - which may or may not work. They have a patchy record, often being taken up by businesses that would have invested in any event, and providing insufficient encouragement to create genuinely new investment. At the same time, he appears to accept the idea of cutting government spending.

While government spending has been rising modestly, and provided a very small cushion against the recession, the private sector is either too cash-strapped to invest, or will not do so because it cannot be confident of profits. The idea, then, that government should forego investment spending, and the economic support it brings the wider economy, is a reckless one. It is premised on the false notion that government investment in a situation such as the present 'crowds out' private investment, as if the economy were a fight in a phone booth. As we have already seen from the investment data, the private sector is in no hurry to invest, the investment strike continues. And taxpayers now own a swathe of the banking sector, so that government could force banks to lend to support any rebound in private sector investment that does occur. Government investment can replace lost private sector investment, especially in areas of extreme falls such as transport, construction, engineering and vehicles. The state may need to increase its direct control over those sectors to achieve that.

But, while it is possible to disagree with Martin Wolf on the likely source of investment over the next period - end entirely disagree with him on the need to cut government spending - it is welcome that influential mainstream economics commentators are now coming to the view that investment holds the key to economic recovery. In his words, 'Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead.'

Source

[1]Martin Wolf 'The world economy has no easy way out of the mire' and 'How unruly economists can agree'

EU calls for Greek population to tighten belts to support wealthy Greek tax dodgers - by Michael Burke

Tactical manoeuvring is continuing among European governments to decide exactly how much of the bill will be picked up by who for the financial debacle in Greece. The one thing they all agree is that Greek workers will not be enjoying a bailout of any kind.

Along with the lowest paid and those dependent on public services, Greek workers will bear the brunt of the 'adjustment process', through wage and welfare cuts, pension reductions, an increased retirement age and other austerity measures. The tactical squabbling is that Greece is being pressed by the European Central Bank and leading EU to go even further in the austerity measures it has already announced.At the same time the Greek PASOK government is facing mass demonstrations and strikes, which have encouraged resistance to further austerity measures.

It is noteworthy who will not be targeted. Greece has one of the lowest tax takes in the Euro Area. In the 15 years to 2006, Greek total general government revenues, as a percentage of GDP, were 37.9% compared to an average rate across the Euro Area of 45.3%.[1] This low level of taxation was, in the Greek case, the source of long-standing budget deficits which were hidden from a gullible or complicit EU (or Eurostat) inspectorate over a number of years.

Greek absence of taxation is also a long-standing burden borne by the poor in the country. The Financial Times reports that, according to the official tax returns, there are literally only a handful of Greek citizens who earn more than €1mn per annum registered for tax purposes, and that the Greek shipping magnates and the other rich are registered as 'non-domiciles' in Britain, and consequently pay tax nowhere.

Greece is not in the financial firing line because of a particularly severe recession or an especially blighted banking sector. The latest estimates from Eurostat show that Greece's GDP fell 2% in 2009, but this compares to -4% for the Euro Area and -4.1% for the EU as a whole. This is shown in Figure 1. At the same time, Greece has committed funds to its banking sector equivalent to 11.4% of GDP - far less than the 31.2% EU average (and 232% for Ireland).[2]

Figure 1

The cause of the turmoil in Greece is its high level of government debt, which existed long before the current crisis, combined with a sharply rising budget deficit. Greek government debt as a percentage of GDP has been hovering close to 100% of GDP in all years this century, and is forecast by the EU to rise to 125% of GDP. Greek bond yields were already rising, but were pushed sharply higher by the decision of the European Central Bank, in effect, to remove Greek government bonds from the list of assets it would hold at the end of this year. A reversal of that announcement alone would transform the attitude to Greek government debt, but has not been forthcoming. Likewise, a genuine transformation of the tax system in Greece, as well as rigorous clampdown on tax evasion by the wealthy, would have a dramatic impact on the deficit.

Instead, it seems as the European institutions are trying to get their act together to act as a quasi-IMF, with any support conditional on a deepening of current austerity measures. This is no more likely to be successful in Greece than it has been in Ireland’s case, where deficit projections continue to rise.

As in other countries the rise in the Greek deficit is caused by a slump in taxation receipts, which have fallen by 8.1% in 2009 and which are forecast to fall by over 10% in 2010 [3]. This hole in government finances is itself linked to plummeting levels of investment in the economy. The recession in investment began a year earlier, in 2008, and has already fallen in total by 22.5%, with further falls expected this year [4]. By contrast, the recession-related rise in government spending over the same two years has been just 3.5% [5]. This is shown in the Figure 2 below.

Figure 2

Greece has a narrow tax base, with an unusually wide range of tax-exempt activities. The tax exemptions are revealing as to whose interests are being protected. Among the tax exempt activities:

• Proceeds from the sale of shares that are traded on the Athens Stock Exchange.
• Income from ships and shipping.
• Any dividend received from a Greek company.
• Capital gain from sale of a business between family members.

As a result, any decline in taxable activity leads to a disproportionate decline in tax receipts. This appears to be the case in Greece, where the slump in investment, which is taxable through a variety of levies on goods and services, has led to the decline in aggregate tax receipts and rising public deficits.

Further, the concealment of the actual size of the public deficits appears to have gone unchecked by the EU Commission - as its own 2004 Report into false public accounting in Greece provided no more than a public admonishment, and no programme for change. The new EU investigation however shows that in the years 2000 to 2003, the public deficit was understated by 10.6% of GDP. And, in a tell-tale sign of the unreformed nature of Greek society since the 1970s, more than half of that, 5.5% of GDP, was on military spending.

There is no economic logic behind spending cuts to close the deficit. Higher spending was not the cause of the budget deficit, lower tax receipts are. Worse, since tax evasion is endemic among Greek businesses and the rich, cutting the income of the one section of society that does pay tax, the poor and salaried workers, will reduce taxation revenues further.

The austerity measures now foisted on Greece stand in sharp contrast to the reflationary measures adopted by the major countries across nearly the entire the Euro Area -a policy led by Germany. German has adopted a reflation/stimulus package amounting to 4% of GDP. Germany's measures could have been better targeted. But despite a stagnant 4th quarter of 2009, forecasts for Germany's growth and its deficit are both on an improving trend.

The question is therefore posed, why is a reflationary recipe that clearly works for 'core' Europe deemed unsuitable for Greece? Why can government investment work for Germany, France, Belgium, and so on, but is ruled out in the case of Greece?

The answer may lie elsewhere, in the countries of Eastern Europe. There a number of countries had been hoping to benefit from further EU enlargement, which now seems postponed. Prior to enlargement, the EU demanded continual reform of the Eastern European economies – including further privatisations, liberalisation of the labour markets and a reduction of social spending.

These privatisations facilitated the arrival of Western European and US telecomms, agribusiness and other firms, but above all banks and financial firms. The drive to lower wages and social spending allowed a cheapening of labour, which could be exploited by Western firms, and led to widespread emigration. The removal of local producers in turn expanded the market for Western goods.

This sounds like the package of 'reform measures' to be demanded of Greece in return for any loans. The Greek population is finding that, while all members of the EU are equal, some are more equal than others.

Sources

1.EU Commission, EcoFin, Europea Economic Forecast Autumn 2009, Statistical Annex, Table 36.

2. EU Commission, Euro Area Report, Winter 2009, Table 2.1.

3. Table 36

4. Table 9

5. Table 35

New China economic data shows declining trade surplus and accelerating economy

The new data for China's foreign trade for July strongly confirms the trend analysed in a previous post on this blog of the strong decline of China's trade surplus.

China's trade surplus in July was $10.6 billion – a fall of 54% compared to the same month in 2008.

This drop reflected the continuing trend whereby China's imports, $94.8 billion in July, have declined much less rapidly under the impact of the financial crisis than its exports - $105 billion in July. In terms of year on year changes China's exports have fallen 23.0% while its imports have only fallen by 14.9%.

There was a small month on month increase in China's surplus compared to June's $8.3 billion, but this was well within the range of expected monthly variations and the 3 month moving average of the surplus declined sharply from $17.3 billion in June to $12.5 billion in July.

The annualised 3 monthly moving average of China's trade surplus was $270.2 billion at the time of China's peak exports in August last year, it rose temporarily under the impact of the financial crisis to a $457.1 billion in January, and is now running at an annualised $150 billion. China's trade surplus has therefore fallen by almost half from the pre-financial crisis levels.

These trends can be seen clearly in Figure 1, which shows China's monthly trade surplus, and Figure 2 which graphs, in order to eliminate purely short term fluctuations, the 3 monthly moving average for China's trade surplus.

The decline of China's trade surplus means that both major 'global imbalances', the other being the US balance of payments deficit, are falling sharply. The reason the US deficit is declining is because US savings are declining but US investment is falling even more rapidly - the result of the sharp US recession. In China investment is rising as a proportion of GDP shrinking the trade surplus and accelerating the economy.As this issue is extremely important for understanding the key trends in the world economy readers may wish to read the article on it on this blog.

While China's trade surplus has shrunk China's year on year growth in the first quarter was 7.1% and accelerating - year on year growth in the second quarter was 7.9%. China's statistical services do not produce official figures for quarter on quarter GDP growth, because it states its seasonable adjustments to economic output are not yet accurate enough, but private economic organisations estimates of annualised growth in the second quarter were 13-15%.

China's official projection for GDP growth this year remains at 8.0%, and other Chinese experts are projecting 8.3%, but Goldman Sachs has increased its prediction of this years GDP growth to 9.4%. While the stimulus package is clearly having a powerful effect the external environment for trade remains very negative and while the Goldman Sachs prognosis certainly cannot be discounted it would appear premature to take as a central perspective that China's growth will significantly exceed the 8.0% central projection.

What the combination of accelerating economic growth and sharply dropping trade surplus does refute is the analysis of those such as Professor Michael Pettis, V. Anantha Nageswaran and others who believe that China's growth is due to an 'Asian model' dependent on large trade surpluses.

China is quite right to aim at a high proportion of exports in GDP, which allows it to benefit from efficiencies flowing from the international division of labour and economies of scale, and this is an integral and necessary part of its growth model. However a large trade surplus, that is a high level of exports unaccompanied by an equivalent high level of imports, does not flow from any economic theory and is not required by China's economic growth - as is confirmed by Figures 1 and 2 which show that the large trade surplus appeared only after 2005 and is now rapidly declining. China's rising rate of investment with its stimulus package is simultaneously allowing its economy to expand rapidly and its trade surplus to shrink.

Figure 1

Figure 2

* * *

This article originally appeared on Key Trends in Globalisation

China's rapidly shrinking trade surplus

One of the areas where most media commentary is lagging behind events is regarding China’s trade surplus. Articles dealing with China’s surplus, one the key international trade trends, have been a regular feature of economic analysis ever since it first appeared in 2005-6. What has not received equal commentary are the signs of a very rapid drop in China’s surplus this year.

This trend is so recent and so strong that the usual year on year comparisons do not capture it adequately. Figure 1 therefore shows China’s monthly trade surplus since 1992 up to the latest available figures for June 2009. Figure 2 shows the same data calculated as a three monthly moving average in order to avoid any purely short term distortions.

Figure 1

Figure 2

The trend is clear and striking. China’s trade surplus rose steadily from 2005 onwards and then temporarily rose even further under the impact of the onset of the international financial crisis in September 2008. The peak was reached in January 2009 with a monthly surplus of $42.1 billion. Since then China’s surplus has fallen steadily and rapidly. The surplus for June was $8.25 billion.

Expressed in terms of 3 monthly moving averages China’s monthly trade surplus was $22.5 in August 2008, immediately before the onset of the financial crisis and the collapse of Lehman brothers, rose to $38.1 billion January 2009, and has since dropped to $12.5 billion.

The trends behind China’s shrinking trade surplus are clear. Under the impact of the financial crisis both China’s exports and imports have declined. But its imports have declined far less than its exports. Since the peak month of August 2008 China’s exports have fallen by 28.0% buts its imports have only declined by 18.5%. China’s net trade position is therefore acting as a locomotive for the rest of the world economy.

Indeed this change in China’s trade position, if the trend continues, is a significant stimulus. The monthly extra demand for the world economy created by China for the latest month, compared to August 2008, is $18.5 billion – its monthly trade surplus having shrunk from $26.7 to $8.3 billion. This would be equivalent to an annualised $220.9 billion.

This trend in China’s exports and imports is insufficient to offset the depressive effect on world trade of the fall in demand from the US. Between August 2008 and May 2009, the latest available figure, the US trade deficit fell by $34.9 billion a month, declining from $60.9 billion to $26.0 billion - equivalent to a net negative shock for other countries' trade of $418.8 billion. Nevertheless it does mean that, if this trend continues, China would be taking up about half the slack in world trade created by the downturn in the US – a far from negligible effect. This trend in China’s trade must therefore be watched carefully.

China’s investment surge aids its own and the world economy - by John Ross

The publication of data for April paints a graphic picture of the present interplay of forces within China’s economy. They also show, so far, the broad correctness of the policies undertaken by China’s government in meeting the international financial crisis and, simultaneously, illuminate the very serious errors of writers such as Martin Wolf, chief economics commentator of the Financial Times, who advocated an entirely different course.

Externally China’s economy continues to be struck with great force by the current collapse in world trade produced by the international financial crisis. China’s April exports were down 22.6% compared to a year earlier. This is a lesser fall than for most countries but necessarily applies severe contractionary pressure to China’s economy.

Internally the Chinese government’s stimulus programme has led to a 30.5% rise in investment in fixed assets in the first four months of 2009 – an increase from the 28.6% year on year increase in the first quarter. Simultaneously China's retail sales in the year to April grew by 14.8%.

The result of the contradictory impact of the negative pressure from the decline in export, and the positive one from internal economic expansion, was the 7.3% year on year increase in industrial output to April. This is relatively low by China’s recent standards but stellar by those of almost all other countries which are suffering major declines in industrial production.

As China’s investment is rising more rapidly than consumption the share of investment in China’s GDP is necessarily rising. While precise quantitative data on the composition of GDP will not be available for some time nevertheless it is possible to judge orders of magnitude.

If it is assumed that China’s overall consumption rises at the same rate as retail sales (which is probably on the high side but no alternative objective measure is available at present),and that retail sales and investment continue to rise for the rest of the year at the same rate as in the first four months, while it is simultaneously assumed the balance of payments surplus declines by 30%, then this implies fixed investment would rise from 43% of China’s GDP in 2007 to approximately 46% in 2009. Evidently there are a considerable number of assumptions in such an estimate regarding trends in the rest of the year but it gives a rough yardstick.

Calculations done by Jing Ulrich, chairwoman of China equities at JP Morgan in Beijing, give a slightly lower estimate - that at present rates of growth investment will account for 45% of China’s GDP this year. Whatever the exact final outcome, therefore, it is clear that the share of investment in China’s GDP is rising.

In the present circumstances this has necessary consequences for China’s balance of payments surplus – given that such a surplus is necessarily equal to the surplus of domestic savings over domestic investment.

It is wholly unlikely that China's total savings level is rising at present given that the state budget is projected to move from balance to a 3% deficit this year, and company profits, the main source of China’s high savings level, are falling as a proportion of GDP under the impact of the financial crisis. China this year will at best have the same savings level as last year, or more probably its savings rate will decline somewhat.

As China’s savings rate is static or falling, and investment is rising, this implies a fall in China’s balance of payments surplus during 2009. China’s broader balance of payments figures will not be available for some time but balance of trade figures are available to April - and the trade balance dominates China’s overall balance of payments position.

The trade figures indicate that China’s monthly trade surplus fell from a peak of $40.1 billion in December to $13.1 billion in April. This figure, however, does not take into account seasonal fluctuations and a comparison with April last year shows a smaller reduction from $16.7 billion to $13.1 billion. The trend in the balance of payments surplus at present, however, is downwards. China’s balance of payments surplus, in short, is likely to fall as domestic investment rises.

This development may be sharply contrasted to the course advocated by Martin Wolf, and others, that China should close the gap between its savings and investment levels primarily by cutting its savings level rather than increasing its investment rate. As has been frequently pointed out on this blog there is a clear factual, as well as theoretical, positive correlation between a high rate of investment and a high rate of growth. China’s economy would slow if it were to reduce its investment rate – something which is not merely undesirable from the point of view of China but, particularly given the present international financial circumstances, is also highly undesirable from the point of view of the world economy. The present course of the Chinese government, which is increasing China’s investment rate, is therefore far preferable to the course advocated by Wolf not only from the point of view of China but from the point of view of the world economy.

Regarding China’s balance of payments surplus itself, while China requires a high rate of investment for a high rate of economic growth there is no reason to be found in economic theory, nor is there any evidence to suggest, that a high balance of payments surplus is any sense a precondition for rapid economic growth. Indeed, as a balance of payment surplus necessarily means that resources are not being productively invested in China, but are being invested in US Treasury bonds, it would be preferable, and secure a higher rate of return, for China to productively use a larger proportion of its assets within China – or put in other terms, the preferable way for China to use its high savings rate would be to increase its domestic investment rate from its previous level.

The argument that has appeared in sections of the foreign language media that China should not increase investment because this will increase ‘overcapacity’ is entirely fallacious theoretically. A high level of investment does not consist in creating more production capacity of the same type at the same levels of technology, efficiency, or productivity – the proposal that China should create more low value added production capacity is evidently false. The issue is high investment to upgrade China’s economy technologically and in terms of productivity and efficiency. Moreover, factually, China is at the beginning of this upgrading of its investment capacity. Capital stock per US worker or per West European worker is very much higher than per Chinese employee. To overcome this lag requires that the investment stock per Chinese worker rise more rapidly than in the US or Europe for a prolonged period.

In addition to direct investment in the workplace the efficiency of any economy, its level of productivity, does not rely only on extra machinery but on the efficiency of a country’s entire productive system including transport, communications, education etc. China has many decades of rapid investment to go through not only in machinery but in infrastructure before its level of capital stock, and therefore overall economic efficiency, even remotely approaches that of the US or Europe. This is merely another way of stating that, in order to achieve the technological and productivity level of the US and Europe, China must go through many decades in which its rate of growth of investment must exceed that of the US and Europe.

Nor, contrary to what is sometimes argued, is a high rate of investment contrary to the environmental needs of China – the exact opposite is true. Environmentally protective policies, for example low carbon emission power generation, is likely to be more expensive than environmentally damaging technology in the short term - although not necessarily in the longer one. To maintain a high level of economic growth in an environmentally protective fashion will therefore require a higher level of investment in China to maintain the same rate of growth – although such investment, of course, will not be in the same technologies as at present.

Increasing its level of investment, therefore, means the technological and productivity upgrading of China – both in terms of immediate productive capacity and the other indirect forms of investment supporting it, and not a merely quantitative expansion of existing technological and productivity levels. In short the argument that extra investment is wrong because it will create ‘overcapacity’ is entirely economically fallacious.

Purely abstractly, from a financial point of view, the highest possible utilisation of China’s savings for a still higher investment within China itself is desirable – which of course, as a by-product, would eliminate the balance of payments surplus. However such abstract financial considerations are subordinate to more practical constraints.

First, in the medium and long run the population of China will gain most from a high rate of economic growth, which requires a high level of investment. That is, the gain in sustainable consumption, both individual and social, which flows from a high growth rate and high investment level exceeds that which would be gained from increasing the share of consumption in GDP. Nevertheless such medium and short term gains must be balanced against short term consumption – with the key criteria being the welfare of the population and therefore its support for the economic system which has brought such success.

Second the rate of investment must be used to upgrade environmentally protective technologies and to replace, not expand, environmentally damaging ones.

Third handling very large investment programmes is not merely a question of allocation of finance but involves material organisation of the economy. As the author is aware of not only from theory but from experience of dealing with large infrastructure projects in London it is considerably easier to make allocations of finance than it is to ensure the efficient delivery of very large scale investment programmes. Whether China possesses the capacity to achieve the latter on any specified scale is a concrete issue that only those in the centre of the relevant economic decisions making have the information to take. Furthermore social, as well as strategic economic growth decisions, must be taken into account.

From an overall financial point of view under the conditions that prevailed in the first half of 2008 prior to the financial crisis, when the Chinese economy faced over- heating and rising inflation, it would, of course, have been dangerous and irresponsible to increase investment further. But now China’s economy is faced not with overheating but an international economic downturn and a potential, if not yet extremely serious, threat of domestic deflation rather than inflation – China’s consumer price index fell by 1.5% in the year to April and its producer price index fell by 6.6% in the same period. Under those circumstances an increase in the rate of investment does not pose the threat of overheating.

China’s investment surge is therefore not only good for its own economy but good for the world economy. Those, such as Martin Wolf, who proposed an alternative course that China should reduce its savings and investment rates were dangerously wrong.

US 1st Quarter GDP - an unprecedented post-war investment fall

Media headlines regarding the publication of the first quarter 2009 US GDP figures concentrated on the 6.1% annualised decline in GDP itself. This was worse than average predictions - which had been for a 4.7% annualised decline. But the most serious development was an unprecedented post-war decline in US investment.

This investment decline is not only dragging the US economy into deeper recession but will have a particular impact in that it precludes any rapid US output recovery.

Analysing first the comparison of the change in US GDP in this business cycle compared to others since World War II, Figure 1 compares the percentage decline in GDP since the peak of the present business cycle, in the second quarter of 2008, with the previous major US post-war economic downturns in 1973 and 1980.

Figure 1

As may be seen, the downturn in US GDP since the second quarter of 2008 is both more rapid and deeper than in any previous post-war business cycle – confirming the by now well established fact that this is the worst US economic downturn since World War II.

However, the downturn in GDP has so far only lasted for three quarters and the total decline to date, of 3.3% is serious but of the same essential qualitative magnitude as the most serious previous post-war economic cycles. It is not, so far, comparable to more serious economic crises – for comparison in 1929-30 US GNP fell by 9.4%.

The conclusion regarding the US GDP itself, therefore, would be that the downturn is very serious but not yet out of the range of previous post-war business cycles. How serious the decline in US GDP will be, therefore, depends on how long the downturn continues and whether US GDP continues to drop.

But the downturn in US investment is of an entirely different and more serious magnitude. Figure 2 shows the downturn in US fixed investment (gross domestic fixed capital formation) in the current business cycle compared to those commencing in 1973 and 1979. As the investment cycle does not always coincide exactly in time with the GDP cycle, in these figures the peak has been taken as the peak of cyclical fixed investment not the peak of GDP.

US investment already started turn down after the first quarter of 2006. As may be seen the present decline in US investment far exceeds those seen in previous post-war business cycles. Furthermore rate of decline of investment was accelerating in the first quarter of 2009.

Figure 2

The total decline in US fixed investment since its peak in this cycle is 23.8%. The year on year decline to the first quarter of 2009 is 18.0%. For comparison it may be noted that the decline in US private fixed investment in 1929-30 was 23.4%. In short if the fall in US GDP in this business cycle does not approach that of 1929 the current decline in US investment is of a qualitatively greater magnitude than any seen in previous post-war business cycles and does approach 1929 levels of decline.

In order to illustrate these trends more clearly Figure 3 shows the changes in the domestic components of US GDP since the first quarter of 2006 - the extremely severe decline in US exports has been analysed elsewhere.

Figure 3

As may be seen while the dimensions of the decline in US GDP and private consumption in this business cycle is relatively moderate, while government consumption overall has not fallen at all, the decline of investment is of extremely severe dimensions.

The result, as may be seen in Figure 4, is not only that US investment has fallen rapidly but its percentage of even a shrinking US economy is declining. US investment has fallen outside its normal postwar range as a percentage of GDP - this US level already being very low in terms of international comparisons.

Comparison to annual figures shows that the proportion of US GDP allocated to fixed investment has now fallen to its lowest level since the immediate post-war reorganisation of the US economy in 1946.

Figure 4

These figures have major implications. In the short term, the decline in investment is dragging the US deeper into recession. But in the medium and longer term such a low level of investment makes it hard to relaunch economic growth.

Furthermore such a level of investment is so low compared to US competitors - China and India both have rates of investment of well over 30% of GDP, that it will lead to further decline in the international competitivity of the US economy.

The implications which flow from the first quarter United States GDP figures are therefore that the US economic downturn is likely to be protracted – which has major implications not only for the United States but for the world economy, and the US economy will continue to fall behind the growth rate of both China and India.

* * *

This article originally appeared Key Trends in Globalisation.

The convulsion in world trade

This blog has analysed on several occasions that the current decline in financial markets, including share prices, has continued for 17 months to match in rapidity that after 1929 – i.e. the most severe recorded.

As may be seen from Figure 1 the rise in share prices on Wall Street in the trading week 9-13 March week did not break out of this declining trend. The shift so far has simply moved the rate of descent closer to the declining trendline that has been operating since October 2007 following several weeks of more precipitate than average falls.

Figure 1

As may be seen from the comparison in Figure 2 the rate of descent of the Dow Jones Industrial Average since October 2007 continues to be as rapid as in 1929 - i.e. it greatly exceeds in speed any other major share decline, apart from 1929, seen since the beginning of the 20th century.

Figure 2

Considering the relation between the financial decline and the productive economy, an article on this blog earlier this month also noted that, for the major industrialised economies, the annualised rate of decline in exports in the last three months has actually been more rapid than in 1929.

The latest statistical data released by the Organisation for Economic Co-operation and Development (OECD) for world trade up to December 2008, with data for more recent months in a few cases, allows the calculation of a picture for a wider range of countries that confirms this trend in striking fashion.

Due to the extremely rapid shift in the situation three indicators have been calculated for exports – the actual year on year decline to December 2008, the actual decline in exports since the peak month for each country or area last year, and the change during the three months to December 2008 on an annualised basis.

In order to give a historical scale of comparison the decline of US exports, in current prices, was 22.5% in 1929-30, 32.7% in 1930-31, 32.4% in 1931-32 and 4.0% in 1932-33 after which partial export recovery commenced - i.e. the most rapid annual rate of decline of US exports in the Great Depression, and the most rapid on record to date, was 32.7% in 1930-31. By 1933 US exports had fallen 66.2% below their 1929 level.

Considering first the OECD area as a whole, and the situation in the European region, the data is set out in Table 1. As can be seen for the OECD region as a whole exports have already declined by over 30% since their peak in April 2008 - essentially equaling the rates of decline of the worst year of the 1930s. The annualised rate of decline in three months up to December 2008 was an astonishing 64%.

For the major G7 economies the decline was only slightly less severe - with a decline of 26.9% since the peak in July and an annualised rate of decline of 57.8% in the three months to December 2008.

Within the Euro area the annualised rate of decline for the three months to December 2008 was 50.4% and for the OECD European region, which includes some East European states, the annualised rate of decline was 67.0%.

It may therefore be clearly said that in the field of trade, as in that of financial markets, the current decline is full comparable in speed of descent to the onset of the Great Depression. The difference, so far, is not in the speed of fall but in its duration. The decline in exports after 1929 continued for four years whereas so far the current decline has been occurring for a year.

Table 1

Turning to individual countries, Table 2 shows the figures for the largest OECD economies - the G7. As may be seen all have seen declines in exports of over 25% since their peak levels last year and in the three months to December 2008 all witnessed annualised rates of decline of more than 50%.

In short, the precipitate decline in world trade, at 1930s rates of descent, is not confined to smaller economies but fully affects the largest ones.

Table 2

Table 3 shows the rates of decline of exports for the non-G7 European OECD states. As may be seen with the exception of two small economies, Luxemburg and Ireland, which have done better than others, all OECD European countries have seen actual export declines of at least 25% and annualised rates of decline of 50% or more.

It is possible that the rate of decline for Spain, an incredible 99.7% annualised rate in the three months to December 2008, is a statistical freak or error but the annualised rates of decline for Sweden, Poland, and Norway are almost as severe - respectively, 79.1%, 82,8%, and 83.1%. Such rates may rightly be characterised not as decline but of collapse of exports in at least the short term.

Table 3

Turning to non-European economies, the data is set out in Table 4. Again, with the exception of the small economies of Iceland and New Zealand, the highly publicised decline of Chinese exports by 22.3% since their peak last year, and at an annualised rate of 53.0% in the three months to December, are themselves actually significantly smaller than for other countries. Mexico and South Korea have already seen actual declines of exports of over 30% and South Africa and Turkey have seen falls of over 40%. The annualised rates of decline of exports for South Korea, Brazil, Indonesia, South Africa, and Turkey - at 70.7%, 72.4%, 78.2%, 82.1%, and 90.1% respectively - are clearly catastrophic.

Table 4

Countries for which OECD data is available for January confirm continuation of the same trend – as shown in Table 5. The chief difference is that with the extra month the actual declines in exports, as opposed to only the annualised rates of fall, have become more serious.

The actual falls recorded from the maximum levels of exports are 29.8% for Switzerland, 41.1% for South Africa, 41.4% for Sweden, 46.3% for Norway and 47.5% for Turkey. There is nothing in this pattern which indicates results for other countries are likely to show an improved tendency.

Table 5

Summarising the above data, of the 34 countries studied 14 had annualised rates of decline of exports of more than 70% and 20 had rates of decline of more than 60%. The widely publicised reports of declines of exports in the last three months of last year such as the annualised 51.9% for Japan, 53.0% for China, or 54.0% for the US, which attracted much publicity, are actually modest compared to the falls in most countries.

While the annualised rates of decline show the extremely striking implosion of world trade during the last three months of 2008 an annualised rate, naturally, indicates an, in this case extremely severe, tendency. What is equally disturbing is the factual falls in exports recorded from the maximum levels last year. Seven countries registered actual falls in exports of more than 40% and 19 of more than 30%.

It should be noted that trade today plays a more significant role in the world economy than at the onset of the 1929 crisis. Exports in an economy with relatively low exposure to trade such as the US now account for 12% of US GDP compared to 7% in 1929 - the figures for most countries are of course much higher. The result of any continuation of such rapid rates of decline of trade therefore, all other things being equal, would be more severe than in 1929.

The transmission mechanisms of the financial crisis into the productive economy are also made clear by such trends. As has been noted previously, initially in the present crisis there was a disjunction between the decline in financial markets, which was of 1929 magnitude, and the situation of the productive economy - which was of a severe but not equivalent decline. As such a disjunction is highly unlikely to continue either financial markets would recover, having overshot on the downside, or the trends and statistics in the productive economy would be shown to have been a lagging indicator and they would adjust downwards to the tendencies indicated in financial markets.

The extraordinarily powerful falls in world exports shown in the latest figures for all major economies indicate that the decline in trade is operating as a key mechanism by which the crisis revealed in financial markets is beginning to affect the productive economy. It may now be said that in two areas of the world economy, financial markets and trade, rates of decline are fully comparable to 1929 scale. How powerful the transmission mechanisms from the international sector are into domestic economies must clearly be carefully studied. The duration of the crisis is also critical - the so far unique severity of 1929 was not only due to the rapidity of the fall but by its duration. The decline in US trade and GDP in the 1930s continued for four years whereas the current decline in financial markets has lasted 17 months, the decline in trade slightly under one year, and the fall in GDP approximately six months.

Nevertheless quite sufficient data are now in to say with certainty that in the last three months of 2008 a convulsion in world trade occurred. The extreme rapidity of the fall in world trade, as with the situation in financial markets, confirms that the benchmark for present analyses must be not only post-World War II recessions but also 1929 itself.

* * *

This article originally appeared on Key Trends in Globalisation

Notes to Tables - peak month for exports in 2008

1. Peak January 2008
2. Peak March 2008
3. Peak April 2008
4. Peak May 2008
5. Peak June 2008
6. Peak July 2008
7. Peak August 2008
8. Peak September 2008

The present present decline in world trade is so far more rapid than in 1929

A crucial question is assessing the current scale of the international economic crisis is examining the relation between the speed of decline in financial markets and the situation in the productive economy. This has direct policy implications as the depth of the economic decline necessarily determines the policies which are adequate to deal with it.

As Socialist Economic Bulletin has analysed on several occasions the rates of present falls on financial markets are entirely comparable to those following 1929 – i.e. the most rapid declines in history. Most published data on the productive economy, however, indicates a rate of decline not approaching that of 1929 – i.e. there is a disparity between the two indicators. An exception is that annualised figures for US GDP for the 4th quarter of 2008 regarding investment, exports and imports indicate rates of declines of post-1929 dimensions. However the annualised figure for US GDP itself for the 4th quarter of 2008 indicates a rate of fall about two thirds as fast as in 1929.

However, a part of this apparent ‘paradox’ of the disparity between financial and productive economy data can be that while financial markets may be followed in real time there is a delay in the calculation and publication of statistics on the productive economy. Current rates of economic decline are sufficiently rapid that delays between the actual current situation in the productive economy and the publication of data regarding it may lead to a significant distortion in the picture presented by at least some statistics.

This is most serious in the case of GDP data which is necessarily published with considerable delay due to the time taken to calculate it – revised data for US 4th quarter GDP figures only became available at the end of February. For that reason other indices than GDP, which may be available more rapidly, may indicate more accurately, if more partially, actual trends. Industrial production data, however, which is frequently taken as a more immediate measure of economic shifts, may be misleading in countries which are heavily dominated by service sector activities.

One of the most important of the available data sources is trade. This also directly relates to one of the key issues in the current economic downturn – globalisation and protectionism. During periods of severe recession a process of trade ‘de-globalisation’ frequently occurs – i.e. exports and imports fall more rapidly than GDP and therefore trade contracts as a percentage of GDP. The most extreme case of such trade ‘de-globalisation’ was following 1929 - when the decline in exports and imports was far greater than that for GDP in the US and other economies and was exceeded in magnitude only by the fall in investment. A similar pattern of the falling share of trade in GDP, on a much smaller scale, was seen during the most severe post-World War II recessions – for example in the US in 1981-82.

This article, therefore, calculates data on recent declines in exports and, as a benchmark, compares these to declines after 1929. The results are extremely striking. They indicate that, at least as regards a series of major countries, the current decline in trade is more rapid than that following 1929. If that process were to continue for any significant period of time the consequences, both in terms of the recessionary pressures that are implied and in terms of ‘de-globalisation’ and the rise of protectionist trends, would be extremely significant. These trends in trade, therefore, also provide some evidence that the extreme pessimism in financial markets, with post-1929 speeds of decline, may be justified by events in the productive economy.

To give an initial benchmark Table 1 shows the decline in exports for countries for which data is available in the first year following 1929. This data is the actual year on year decline measured in current price terms. As may be seen all countries suffered major export declines - the most severe contractions being in the US, Japan, Canada and the UK.

For comparison Table 2 shows the export trends to December 2008 for a series of major trading countries. December has been taken as the cut off point as Asia’s, and to a lesser extent other regions, trade figures are highly distorted by the fact that the Chinese lunar New Year holiday fell unusually early this year in January. This distorts year on year comparisons for January and February 2009.¹

It should be stressed, therefore, in the light of the magnitude of the shifts revealed, that as the economic situation has been deteriorating the figures calculated to December indicate the scale of falls conservatively. It is likely trends worsened in January and February.

To indicate the rate of deterioration three figures are shown in Table 2 – the actual year on year fall in exports to December 2008, the six month June-December 2008 decline on an annualised basis, and the three month September to December fall on an annualised basis.

It may be seen that the rates of decline of exports in the last half of 2008 were of extraordinary magnitudes – even considerably exceeding the rates of decline seen in 1929-30. For the US to have suffered annualised rates of decline of exports of 32.6% for the last six months, and for 44.5% for the last three months is, respectively, half as much again as, and almost twice, the decline seen in 1929.

The annualised rates of decline for the last three months in South Korea and Japan, 71.8% and 81.5% respectively, may well have no equivalents for peacetime in major countries in history. Even the annualised figures for the rates of decline for exports for the last six months for Germany, South Korea, and Japan – 42.0%, 46.3% and 54.5% respectively – are at speeds which considerably exceed those for 1929.

An immediate caution must be made that an annualised rate of decline, even one based on a six month period, is not the same as an actual annual decline. In most countries the decline in exports commenced in July 2008 (in March 2008 in Japan and in October 2008 in Germany) and therefore actual year on year results for the period since then will not be available for some months. But the scales of drop in the last six months are so sharp that there would have to be an extremely great, and in the economic circumstances highly unrealistic, recovery of trade in the next few months for the declines in exports on a year by year basis not to be at least as bad, and probably worse, than those for 1929-30 – in some cases worse than 1929-30 by a significant margin.

As a further control on the data to avoid exaggeration Table 3 shows the actual (i.e. non-annualised) decline in exports since the peak month for the countries concerned. The trends, again, are evident. In all cases the actual drop in exports that has already taken place since the maximum levels last year is essentially equal to or exceeds that seen in 1929.

Such rates of decline cast further light on the apparent differences between the post-1929 scale of falls on financial market and the apparently much less severe declines in the published statistics for the productive economy. Such extreme falls in exports/trade increase the probability that financial markets are behaving rationally and that at least part of the apparent disparity between the post-1929 scales of decline in financial markets and the lesser falls in published statistical data is due to the time lag in statistical calculation – i.e. that the actual situation in the productive economy is worse than it appears from the necessarily time lagged published data.

Second, it indicates that the 4th quarter US GDP data, which indicated an extremely severe and rapid deterioration in trade, is not exceptional but may be repeated for other countries.

Such figures indicate that in at least one area, trade, the rate of decline in the productive economy is now at least as rapid as after 1929 – i.e. the most severe ever recorded in peacetime history.

The implications of this for policy are clear. If will take further data to be available to show the exact significance of this extremely rapid decline in trade - whether it will halt relatively rapidly, whether declines in GDP will also speed up greatly, or whether a sharp process of 'de-globalisation' occurs (i.e. trade falls very sharply but GDP does not, leading to a decline in the share of trade in GDP). But the trend in exports confirms the picture of the 4th quarter figures for US GDP regarding investment and trade - i.e. that the 'gap' between the extreme decline in financial markets and the less rapid decline in published statistics for the productive economy is so far being filled by a more decline in the productive economy not a recovery by financial markets.

As was stated in a previous post on SEB such a situation means that: 'the appearance of such tendencies clearly means that governments, policy makers and companies should not be seeking to minimise the gravity of what is taking place. It is more imperative at present to prepare for worse case scenarios than optimistic ones.'

Notes

¹ For example South Korea’s export figures show a 32.8% year on year decline for January 2009 compared to a similar 17.3% year on year drop for February with this being likely to reflect not a rebound but depressed figures for January due to the holiday.

India and China

The international financial crisis is shaking up and reshaping many economic relationships. One at the top of that list should certainly be economic relations between India and China.

The complementarity of the two countries in the present international financial situation is evident. India has naturally been affected by the international financial crisis but its economy is still continuing to perform strongly compared to almost all other countries - while GDP growth is almost certain to have decelerated from the 7.6% year on year year increase recorded in the third quarter, India will continue to be one of the few major economies experiencing economic growth this year and India's industrial production in December was down only 2.0% year on year, which is far superior to current performance in most countries. India's macro-economic fundamentals, particularly its high savings and investment rates, continue to be strong. China continues to register economic growth and its savings and investment rates are the highest in the world.

In short, India and China will be the world's two best performing major economies in 2009 and therefore able to offer more favourable markets for each other than almost any other combination of countries.

The Indian government, however, is quite open about the fact that India cannot finance alone all the infrastructure investment it requires to sustain its rapid economic growth at present – short term and medium term project requirements by themselves amount to over $250 billion. Meanwhile India's budget deficit of 6% of GDP limits the room for manoeuvre of the government in publicly funded infrastructure development.

China, however, is not only very strong financially but also has highly experienced companies capable of leading infrastructure projects. Simultaneously India has areas of great strengths where it has achieved leads over China – in a number of service sectors led, of course, by software in which China can benefit from Indian expertise. The two economies, in short, have developed significant complementarities. Discussions between India and China governments on economic issues would therefore seem to be a high priority.

The main obstacle to this at present would seem to be circles in the US which are seeking to create tensions between India and China for political purposes and some short sighted figures in India who are prepared to go along with such an agenda. The US is, however, in no position to aid India economically or to undertake the scale of infrastructure and other economic development which India requires to sustain its growth rate. Tension between India and China therefore damages India even more than China.

Economic relations between the world's two most rapidly growing major economies will therefore be a matter of great interest during the current financial turmoil.

* * *

This article appeared on the blog Key Trends in Globalisation.

UK bank 'insurance' scheme will become even more unpopular because it is economically wrong

Unsurprisingly it was the Tories who proposed the new scheme whereby UK bank loans will be insured by the state - a method whereby losses made by the private banks are 'nationalised', that is underwritten by the tax payer, while bank shareholders have share prices propped up by taxpayer guarantees. It is, in short, a system whereby bank shareholders siphon money from the tax payer.

This scheme is wrong from the point of view of economic policy - what is required from an economic point of view, as Socialist Economic Bulletin has pointed out, is bank nationalisation in order to ensure lending to the economy restarts. Under the present scheme bank shareholders will continue to take tax payers money as profits instead of all money being used for counter-cyclical bank lending.

Precisely for that reason the scheme will be deeply damaging politically - people will understand their money as taxpayers is being siphoned off to the bank shareholders and bank managements who took the decisions which are responsible for the present deep economic crisis. The scheme is therefore already unpopular for that reason and it will become more so as the taxpayer begins to pick up the bill.

That the Tories should propose the public is robbed by companies is natural -that is why they proposed the scheme. But Labour should not be supporting it. Nationalisation of the core of the UK banking system is what has been required since last autumn and it should be proceeded to before even more billions of taxpayers money is lost.

The Sunday Times gets it on how China is using state owned banks to fight the recession

The Sunday Times today carries an article by Leo Lewis that factually sets out the way in which bank lending in China is now rapidly soaring as a part of its counter-cyclical strategy. This is, of course, in sharp contrast to the situation in Britain - where banks are sharply contracting lending, seriously worsening the economic downturn, despite the fact that they have received tends of billions of pounds in taxpayer bailouts.

The reason for the difference is, as Socialist Economic Bulletin has pointed out, of course that with a state owned banking system, as in China, banks can be instructed to increase lending as a central part of the strategy to fight recession. With a privately owned banking system, as in the UK or US, bail out funds put in by the taxpayer are appropriated by the need to deliver profits to bank shareholders and no increase in lending takes place.

Lewis attempts to present matters from the shareholders point of view - warning that such large scale lending programmes as in China are putting the needs of the economy before that of shareholders. But the needs of the economy should come before those of shareholders. A state owned core of the banking system allows lending to be maintained, or expanded, when faced with a severe economic downturn - which is what is required for the economy. A privately owned core of the banking system, such as in Britain, means bank lending shrinks when confronted with serious economic recession - the opposite of what is required.

Lewis's factual description of what is occurring in China shows clearly that a sharp contraction in bank lending, severely worsening recession, is not 'an act of god' which cannot be avoided. It is a consequence of subordinating the interest of the economy to those of private bank shareholders. The way out is to take the core of the banking system into state ownership and re-commence lending to the economy. Present policy in China shows what is required in this field.

Lewis notes: 'Gripped between the jaws of financial and economic calamity — and knowing that the banks hold the answer to everything — there are two choices a government can take with the sector: caulk and coddle or maim and martyr.

'It is still early days, but with new bank lending soaring 1,000 per cent year-on-year in December, it looks very much as though China is taking the Joan of Arc (maim and matyr) option.

'China’s banks may appear to be more like market-traded, market-led institutions than they did ten years ago, but that view is wishful at best... The biggest exposé of the banks’ true nature comes in the form of a recently produced graph of new bank lending in China, dating back four years. Between April 2004 and October 2008, the line bounces around in much the way you would expect it to in a booming economy with lots of simultaneous investment cycles and bubbles. Between November 2008 and now, it suddenly goes up. Vertically.

'The 1,000 per cent surge — a slew of 772 billion yuan in new loans to companies and projects — dates almost exactly from the moment lending quotas were scrapped and regional banks were told that their loan to deposit ratio could legally drop below 75 per cent. M2 — the sum of all cash and deposits — soared 18 per cent in the same month... as CLSA’s China strategist Andy Rothman puts it: “in China, there is only a credit crunch when the political leadership wants one.”... For those who truly believe that restarting the lending cycle again is a guarantee of sustainable Chinese growth above 8 per cent, the unfettering of the country’s banks could even be more significant than the government’s $580 billion spending package... The China Banking Regulatory Commission... endorsed a massive increase in lending to small firms...

'What sort of post-dated cheques has Beijing written out as guarantees to the banks that are now loyally doing the government’s bidding? Lurking behind the scenes, there must be informal absolutions offered for the banks that lend themselves to death. Good for them, good for Beijing and, probably, good for longer-term stability in China.'

What happens in a recession?

The government's recovery package has gone in the right direction in the area of seeking to maintain consumption during a recession.
The cut in VAT will concentrate tax relief on the average and lower paid - which is what is required from the point of view of both keeping up consumer demand and social justice. There can be discussion about whether the consumer spending stimulus package should have been larger, and whether the restrictions on government spending are necessarily the best thing in current economic circumstances. But overall the package is a commitment to an unambiguously Keynesian approach and, in the fields of consumer and government spending it can, if necessary, be boosted later in any case.
But it is vital to realise that in a recession what is decisive is neither consumer nor government spending. What, above all, occurs in a recession is that investment declines or, in the most severe cases, collapses.
In order to illustrate this Figure 1 shows the changes in the main domestic components of US GDP in the most classic of all recessions/depressions - that in the US following 1929. [1]

Figure 1

As can be seen the pattern is clear. The economic decline in US was extremely severe - on a far larger scale than anything occurring at present. The fall in US GNP (Gross National Product) was 29.7 per cent between 1929 and 1933.[2] The 1929 US level of GNP was not regained for a decade - until 1939.
Looking at the components of this decline in GDP, however, a clearly differential pattern shows itself.
Government spending increased throughout the recession - not only after Roosevelt became president in 1933 but even under Hoover.
The decline in personal consumption expenditure after 1929 was severe but less than the overall decline in GNP. By 1933 US personal consumption expenditure had fallen by 19.7 per cent compared to the 29.7 per cent drop in GNP. Personal consumption expenditure regained its 1929 level by 1939.
But the collapse in investment was extreme, far exceeding the decline in GNP - explaining the difference between the drop in personal and government consumption expenditure and the drop in overall output
By 1933 US private domestic fixed investment had fallen by 73.9 per cent from its 1929 level. Or, put another way, by 1933, US private domestic fixed investment was only 26.1 per cent of its 1929 level. This was by far and away the most severe element of the depression - which, by multiplier effects, spread its consequences through the rest of the economy.
The reason for this differential decline is that while 'demand' may be spoken of in general, in fact the different components of demand are controlled by quite different mechanisms.
Decisions on the level of government spending are taken directly by the state and can therefore be relatively easily controlled.
Regarding personal consumption, the aim of the mass of the population is to have as good a living standard as possible. The most powerful issue affecting personal consumption is the level of income, not the desire to consume. [3]
However, private investment decisions are not controlled by consumption but by profit. Therefore investment decisions are not controlled by the same mechanisms as personal and government consumption - and can fall to almost any level. It is this decline in investment which is by far the largest in a recession.
Why, therefore, cannot the government intervene directly to stop the decline in investment? The issue here is private property in the means of production. If the government takes decisions on investment out of the hands of the private owners of the means of production it, in fact, limits or abolishes that private ownership of the means of production. Therefore, in such circumstances, if the government continues to accept as private ownership of the means of production as an absolute right if cannot halt the decline in investment. Whereas if, in such circumstances, the government aims to halt the decline in investment it must encroach on private ownership in the means of production.
The practical consequences in terms of economic policy are clear. If a recession is relatively mild, acceptance of private ownership in the means of production, and therefore the inability to control investment, may at worst be wasteful but it will not be fatal. The government still has tools to increase its own, state funded, consumption demand - it can, for example, embark on huge new health or education programmes. In terms of personal consumption there is a very severe issue in terms of maintaining demand which is posed by unemployment - overall consumer spending can fall not only because wages drop but because the number of those in work falls. However the government can still carry out large increases in welfare benefits, cuts in taxation, or public works schemes that can significantly support consumer spending.
But in the area of investment the government has no comparable instruments. Approaching one fifth of the economy is accounted for by investment - and this investment also determines the long term economic growth. Public investment is a tiny fraction of this. While the government has powerful levers in the areas of state and personal consumption it has no comparable ones in investment. Nor can it have them without a encroachments on private ownership of the means of production. [4]
This will, therefore, determine the unfolding of the economic situation. There is going to be a severe recession - in terms of comparison to those since World War II. But a severe recession, in those terms, is naturally relatively mild compared to the type of economic crisis after 1929. While the financial crisis is clearly the largest seen since 1929 the downturn in the real economy does not remotely approach that of the Great Depression. The probability is that the current crisis will remain a very severe recession and but there will not be an economic depression - although this depends on the US adopting policies that avoid the type of disastrous errors that followed 1929.
If the economic downturn remains at the level of a recession then Keynesian measures will succeed, after a period, in bringing about a new economic upturn without any severe incursions into private ownership of the means of production - outside of the financial sector where they have already taken place. That is, put in other terms, the moral case for socialism will remain. But, while the role of the state, in a capitalist economy, will require to be increased in order to overcome the economic crisis - something which is already happening, it will not require a transition to a socialist society to overcome the economic downturn. If, however, the present severe recession were to pass over into an economic depression then another outcome would be posed.
It is at this point that the moral and economic cases for socialism become inseparable. A capitalist economic solution says private property in the means of production must be regarded as absolute, and untouchable, even if that means economic collapse - this answer says the rights of capital are absolute and the rights of society subordinate. A socialist solution says that if, in order to avoid economic collapse, it is necessary to make encroachments into the rights of private property in the means of production then this must be done - it is the rights of society that are absolute and the rights of capital are subordinate to this.
These 'cold' figures on the movement of components of GDP during a recession therefore spell out, in their own way, the structure of society - that one part of the economy is controlled by the desire of people to consume, that is to enjoy a better standard of life. That another part of the economy is controlled by profit. And that the interests of the two may clash.
How far they will clash during this economic downturn, and with what outcome, remains to be seen. But the socialist answer is simple. It is society, that is people, which comes first - not the private ownership of the means of production.


Notes
[1] The international source of demand is net exports. There was a drastic contraction of international trade after 1929 which seriously deepened the depression. However this does not affect the argument regarding the components of domestic demand dealt with here. Inventories also declined after 1929, adding to the recessionary effect, however changes in stocks, by their nature, are cyclical and again the concentration here is on the long term elements in economic shift.
[2] Gross National Product (GNP) differs from Gross Domestic Product (GDP) in that is equal to GDP plus net income earned from abroad. Long term US historical economic data is in GNP terms. The size of difference to GDP is, however, small and does not seriously distort comparisons to other countries GDP figures.
[3] In a recession personal consumers may decide to save more - among other reasons to protect themselves from the threat of future economic hardship or unemployment. However there are relatively effective mechanisms to tackle this, and in any case if the extra savings are invested by the government or companies no fall in aggregate demand takes place - the savings by individual are merely spent somewhere else in the economy. The biggest effect is the fall in income due to either declines in real wages or unemployment.
[4] Such encroachments may be through large scale expansion of areas of public investment, taking over areas at present controlled by private investment, or both.

Dow Jones so far continues to track its 1929 decline

Socialist Economic Bulletin has emphasised the significant danger in current economic and government policy of underestimation of downside risk in share prices. This is fully confirmed by the latest movements of the Dow Jones Industrial Average which are illustrated in Figure 1.
This graph compares the daily movement of the Dow following its peak on 3 September 1929 with its movement following its peak on 9 October 2007. As may be seen the decline in the Dow in the current financial crisis is entirely comparable in magnitude, at this stage, to its fall in 1929-32 - this data updates trends analysed in SEB in October.

Figure 1

In order to show that such a severe decline in nominal share prices is a specific feature of the 1929 and 2007 crises, and not typical of any recession, Figure 2 shows a similar graph for the four most serious declines in the Dow in the last century - those starting in 1929, 1973, 2000, and 2007.
For the three earlier declines the data covers the period from the peak price preceding the decline to its low point. The data for the decline starting in 2007 are up to the latest available date - the close of trading on 20 November 2008.

Figure 2

It may be seen that the falls in nominal prices starting in 1973, associated with the oil price increases and recession of that year, and in 2000, following the bursting of the dot com financial bubble, were far less severe than the drops in either 1929 or in 2007.
The fall in real terms following 1973 is understated by this graph, as at that time inflation was far higher than in 1929, 2000 or 2007, while the decline in real terms following 1929 is somewhat exaggerated as at that time the overall price level in the economy was falling. But the differences of order of magnitude are sufficient to make the pattern clear. The fall in nominal share prices following both 1929 and 2007 far exceeds that of any other drop in the last century.
From the angle of share prices it is entirely justified, and without exaggeration, to speak of the present crisis as comparable only to 1929.
The difference between the fall starting in 2007 and that in 1929 is only, at present, the duration of the decline. The decline after 1929 continued for 712 trading days before reaching its bottom on 7 July 1932. The decline following the peak of 9 October 2007 has so far continued for 284 trading days - slightly under forty per cent of the period of the decline following 1929.
Far more prolonged falls in share prices than in 1929 are, however, possible. The Japanese Nikkei, to take the extreme case, was still setting new lows 18 years following its peak at the end of 1989.
For these reasons, to return to the point made at the beginning, there continues to be considerable underestimation of downside risk in share prices in current economic and government policy.

* * *

This article is a shortened version of one which appeared on Key Trends in Globalisation.