US 2nd quarter GDP figures - investment remains the key issue for US recovery

By John Ross

The publication of the US 2nd quarter GDP figures highlighted several striking and interlinked structural trends in the US economy. These go considerably beyond the well publicised slowing of the US economic recovery. They again make clear that the trajectory of the US economy will be determined by what happens to US fixed investment

The data confirms the US recovery is weak

Unsurprisingly, because it was anticipated, and as has been widely reported, the data confirmed the slowdown in US economic recovery. Taking the latest revised figures, annualised US GDP growth decelerated from 5.0% in the 4th quarter of 2009, to 3.7% in the 1st quarter of 2010 to 2.4% in the 2nd quarter.

US GDP remains 1.1% below its peak level in the 4th quarter of 2007. At the 2nd quarter’s rate of growth previous peak US GDP will not be regained until the 4th quarter of 2010.

Such figures have essentially decided the debate between those who argued that because the US downturn was very severe its economy would spring back strongly from recession, and those, such as the present author, who pointed to the underlying structural situation of the US economy and therefore argued recovery would be weak compared to previous US post-war business cycles.

Figure 1 illustrates how much weaker the present US economic recovery is than in previous post-war cycles. In the previous most serious post-war cyclical downturn, that following 1973, the US economy regained its previous peak level of production after eight quarters. In this recession after 10 quarters the US economy has still not recovered its peak GDP level.

As also widely reported, the new GDP data now calculates the US recession was deeper, and started earlier, than previously estimated. Peak US GDP is now analysed as having occurred in the 4th quarter of 2007 rather than the 2^nd quarter of 2008 as previously estimated. The trough of US GDP in the 2nd quarter of 2009 is now calculated to have been 4.1% below the cyclical peak level - the previous deepest fall in a US post-World War recession, that after 1973, was 3.2%.

Figure 1

The fall in US investment

The driving force of the depth of the US recession is also clear. It was due to the decline in US fixed investment. As shown in Figure 2, measured in constant 2005 prices, US GDP in the 2nd quarter of 2010 was $147 billion below its 4th quarter 2007 level. However several components of US GDP are already above their 4th quarter 2007 levels - inventories are up $63 billion, government consumption up $112 billion, and net trade up $135 billion. Consumer expenditure was below its 4th quarter 2007 level but only by $80 billion. But US private fixed investment was down $412 billion - dwarfing all other contributions to the recession.

Figure 2

Decline in investment centred in non-residential sector

This decline in US private fixed investment was not primarily due to the fall in residential investment created by the sub-prime mortgage crisis - as may be seen from Figure 3. The decline in US residential fixed investment, again in 2005 dollars, was $172 billion whereas the decline in non-residential fixed investment was $241 billion.

Figure 3

Fixed investment and inventories

A further feature indicating the specific pattern of US recovery is the financing of gross domestic investment - i.e. fixed investment plus inventory accumulation. Although, as noted above, US fixed investment remained severely depressed, nevertheless for the first time for four years there was a small upturn, of 0.5%, in the percentage of US GDP devoted to fixed investment in the 2nd quarter - fixed investment rose to 15.6% of GDP from its low of 15.1% in the 1st quarter of 2010. This reflected a stabilisation of the share of residential investment in GDP and a slight increase in the share of non-residential investment - see Figure 4.

Figure 4

However it is clear that the majority of the saving necessary to finance the small upturn in overall gross investment has come from a worsening of the US trade balance - i.e. from foreign borrowing. Since the low point of the recession, in the 2nd quarter of 2009, US fixed investment and inventory accumulation has increased its share of GDP by 1.6% - rising from 14.5% of GDP to 16.1%. However this increase was entirely due to inventory accumulation - the percentage of US GDP devoted to private sector inventory accumulation rose by 1.9%, from -0.6% of GDP to +1.3%. However US fixed investment declined by 0.2% of GDP in the same period - from 15.8% of GDP to 15.6% of GDP.

Precisely quantifying the contribution of borrowing abroad to the financing of inventory accumulation is not possible until the US balance of payments figures for the 2nd quarter are published in September. However US balance of payments figures are dominated by the US balance of trade. The US trade deficit has been steadily widening since the depth of the recession in the 2nd quarter of 2009 - see Figure 5.

The deterioration in US net exports in 2nd quarter 2009 to 2nd quarter 2010 was 1.1% of GDP - the trade deficit rising from 2.4% of GDP to 3.5%. This is equivalent to 69% of the increase in the percentage of GDP for investment - indicating that the majority of financing for the increased saving to finance inventory accumulation has come from abroad. Given that in this period there was no increase in fixed investment at all what is occurring is that the US economy has been borrowing abroad not to finance fixed investment but in order to fund inventory accumulation.

Borrowing from abroad to finance an inventory build up, rather than for investment in fixed assets which can increase productivity or capacity, cannot be considered a healthy pattern of growth.

Figure 5

How is the US economic downturn to be overcome?

The data above makes clear that the quantitative key to overcoming the US economic downturn remains the situation in US fixed investment. Some reports on the 2nd quarter GDP figures spoke of a 'surge' in US business investment in the quarter but this fails to place the increase in a long term context. Comparing 2nd quarter 2010 to 1st quarter 2010, total US private investment rose by an annualised 19.1% or by $84 billion in 2005 prices. This sounds dramatic until it is noted that between 4th quarter 2007 and 2nd quarter 2009 US fixed investment fell by $495 billion so that the 2nd quarter 2010's increase made up only 17% of the fall that took place to the trough of recession. Only if an investment recovery continues for many quarters will the severe fall in US fixed investment during the recession be made up.

Such a fixed investment wave, in turn, would have to be financed by an equivalent rise in savings and therefore either by a sharp increase in US domestic savings or a large inflow of foreign capital. The former would require compression of US consumption, which would be likely to create major political unpopularity for the Obama administration, while the latter would require a major widening of the US balance of payments deficit. So far, as noted above, the primary process which has taken place is a worsening of the US trade deficit.

Why does the US not launch a major state investment drive?

Some authors argue that the way out of this current situation is for the US to launch a major state financed investment programme - a coherent exposition of this argument is presented for example in Richard Duncan's The Corruption of Capitalism. The arguments of adherents of this view is that due to the debt laden situation of the US private sector, and therefore its inability to sustain large scale expenditure, the US government, to maintain economic demand, has in any case no option but to continue to run large scale budget deficits for the foreseeable future. Therefore, instead of being used to maintain consumption, as at present, the budget deficit should instead be used to increase investment. As Duncan argues:

'Trillion dollar annual deficits for the next decade may keep the United States from collapsing into a severe depression.... But they would do nothing to restore the economy's long-term viability... The trade deficit would still be massive... The country could continue to consume more than it produced as long as other countries continued to accept its IOUs. But with each year that passed, structurally the economy would become increasingly rotten...

'There is a much more attractive alternative future, in which the United States remains the world's dominant superpower with a revitalised, self-staining economy. That alternative requires a national industrial-restructuring programme in which the government would invest in 21st Century technologies with the goal of establishing an unassailable American lead in the industries of the future. That goal could be achieved at the cost of $3 trillion over 10 years.'(1)

Such a programme for reversing the US investment decline is intellectually coherent but unfortunately in practice it is impossible to deliver given the structure of the US economy. The reasons why this is the case also show why the the Obama administration has been unable to step in and launch any large scale state financed investment programme.

The first obstruction is political - any US administration pursuing such an approach would get little or no popular support for doing so. Popular political sentiment is not determined by GDP growth statistics, let alone investment statistics - about both of which most of the population knows little and cares less. Political popularity is determined by whether living standards are rising or falling. Whereas government programmes boosting consumption improve living standards, and therefore are popular, programmes boosting investment have no such direct effect and are therefore unlikely to be generate equivalent political popularity.

More fundamentally, at the economic level, large scale government intervention in investment would alter the balance between the state and private sectors in the US and increase the weight of the former. This would therefore require a sharp shift in the structure of the US economy and would also be strongly resisted on ideological grounds.

It is for this reason that while the Obama administration has been able to use the budget deficit with considerable effect to maintain both private and government consumption it has been unable to have any significant effect on US investment. As may be seen in Figure 6, expressed in current prices, the $41 billion increase in US state investment between the 4th quarter of 2007 and the 2nd quarter of 2010 offset only 8.5% of the $485 billion decline in private investment which took place in the same period.

Figure 6

Furthermore whatever increase in state investment did take place was almost entirely in the ideological acceptable, but economically unproductive, field of military spending. As may be seen in Figure 7, between the 4th quarter of 2007 and the 2nd quarter of 2010 while US Federal military fixed investment went up by $28.8 billion in current prices, Federal civilian investment went up by only $9.0 billion and fixed investment by the fifty US States went up by only $3.0 billion. Therefore not only was the total increase in US state investment far too small to offset the fall in private fixed investment but the increase in civilian state investment was negligible. Figure 8 shows the same trends in fixed price terms.

The idea of state action to overcome the investment decline in the US is therefore interesting in theoretical terms. But it is impossible to execute in the actual structure of the US economy.

Figure 7

Figure 8

China's response compared to the US

Several conclusions follow from the above data.

• It is evident why the US recovery from recession has been weak and is likely to continue to be so - a huge decline in fixed investment has to be made up.
• It is likely the US trade deficit will continue to expand. Financing a recovery in investment from US domestic savings would be likely to require compression or slow growth of US consumption which would be highly unpopular. It is therefore easier for the US economy to finance an investment recovery through expansion of foreign borrowing - i.e. to widen the balance of trade deficit.
• It is evident why China has come so much more successfully through the international financial crisis than the US. As has been analysed elsewhere the general overall characteristic of the present 'Great Recession', internationally and not simply in the US, is a severe decline in fixed investment. China's own stimulus programme however, by directly boosting investment, ensured that no such decline took place in China. On the contrary, the period following the start of the international financial crisis saw a sharp increase in fixed investment within China.The programme prescribed by Richard Duncan and others for the US - 'a national industrial-restructuring programme in which the government would invest in 21st Century technologies' - is impossible for the US to execute for reasons already analysed. However it appears to be rather close to what China is actually executing.
Far more successful economic performance by China than by the US therefore seems certain to continue in the next period with its concomitant consequences for the world economy.

Notes

1. Richard Duncan, The Corruption of Capitalism, CLSA Books, Hong Kong 2009.

Germany's 'continental economy' - comparisons to the US, India and China

Data released by the German statistical service shows how much Germany, until this year the world's largest exporter, and still the second largest, relies on its European market - particularly in a period of severe economic downturn such as 2009.

Approximately three quarters of German exports were to European countries. 63% of all exported German goods were delivered to the member states of the European Union.

Asia, the second most important market for German export goods in 2009, trailed far behind with 14% of German exports. The US accounted for 10%.. Africa and Oceania (including Australia) accounted for only 2% and 1% of German exports.

In terms of imports Germany was almost equally Europe dominated. 71% of Germany's imports came from Europe, with 18% from Asia and 9% from the US. Goods from Africa and Oceania represented just 2% and 0.4%, of Germany's imports.

Germany's economy, in short, is not really a balanced 'international' one - in particular in an economic downturn. It is, in export terms in particular, a European continental economy with secondary add ons in Asia and the US.

What implications flow from this?

The first is to reinforce the decisiveness of preserving the Eurozone for Germany - as against somewhat facile talk that the Euro may split or disintegrate. Germany has by far the highest percentage of exports in GDP of any major economy - 47.1% on the eve of the international financial crisis in the 2nd quarter of 2008. This has increased hugely, from 28.0%, since the introduction of the Euro.

The fact that Germany is operating in a continental scale economy, Eurozone Europe, with a fixed exchange rate, allows it to gain or maintain tremendous economies of scale. Conversely introduction of unstable exchange rates,including the possibility for major European trading partners to carry out competitive devaluations, would almost certainly make it impossible for Germany to maintain such a high proportion of exports in its economy - that is it would greatly weaken the 'continental' scale of its economy. The Euro, in short, is not a 'monetary union' but a decisive mechanism for Germany to enjoy the advantages of a continental scale economy. As the gains are great German economic policy, being rational, can pay a major price to maintain the Euro - something to be kept in mind in the coming battles over debt in Greece, Portugal and Spain.

Second, the trade data casts an important light on the optimal size of a modern economy. It is well known that the world's largest and most productive economy, the US, has only a relatively small share of foreign trade in GDP. In the 2nd quarter of 2008, prior to the recent decline in world trade, exports accounted for 13.6% of US GDP and imports for 18.5% - evidently far below German levels. Exports of goods and services were only 5.7% of US GDP in 1929, 3.4% of US GDP in 1938, and 7.0% of US GDP in 1950.

The reason for the far more self-contained character of the US economy, of course, is the fact that it was the first continental scale integrated economy in history. The second continental scale economy was the USSR, which has since disintegrated, the third is China and the fourth is India. Germany's economic configuration is that of the single most important component of a continental scale economy attempting to come into existence in Europe. Whether it succeeds or not of course depends on the future course of European integration.

These parameters also cast a very interesting light on possible future dynamics of China's economy. China's economy is far more open than any economy of its scale has been historically. In real, that is parity purchasing power (PPP), terms China's has already been the second largest economy in the world for several years. In PPP terms China's economy is slightly over half the size of the US - on IMF calculations $7.9 trillion compared to $14.3 trillion. In terms of percentage of GDP, at official exchange rates, China's exports of goods and services peaked at 39.1% of GDP in 2006 - far exceeding the ratio of exports to GDP of the US. By 2008, under the impact of the upward movement in the exchange rate of the RMB, and the beginning of the international financial crisis, exports of goods and services had fallen slightly to 35.9% of China's GDP.

If China's exports in dollars are compared to a parity purchasing power figure for its GDP, however, then exports are only 20% of GDP. This is still above the figure for the US but not vastly so. It is entirely possible that as the size of China's GDP at official exchange rate grows towards US levels, both through economic growth and revaluation of the RMB, the percentage of exports in China's GDP will actually decrease. Unlike the historical pattern of most economies, which developed on the basis of their domestic markets and then expanded into exports, China may develop on the basis of exports and then statistically partially 'retreat' into a large scale domestic market. This would be a type of economic 'convergence' towards the type of $15 trillion GDP economy which is the scale represented by both the US and the EU.

Such a development would, of course, not be a retreat of China from globalisation - the absolute scale of China's exports, imports and inward and outward investment would continue to rise, but it casts the present rebalancing of China's economy towards domestic demand in not only a tactical but a strategic light. The only proviso that needs to be made, because of some confusions expressed in sections of the press, is that 'domestic demand' for China, as for every country, does not consist only of domestic consumption but also domestic investment. The present rise in the proportion of both domestic investment and domestic consumption in China's GDP, at the expense of its trade surplus, would constitute part of that process.

The process of 'globalisation' should therefore not hide the reality that the present is also an epoch of the integrated continental scale economy - with a common state to sustain a common currency, a unified budget, and the other features of an integrated economy. The US, China, and India have all created this, even if they are at different levels of economic development. Europe has not. Champions of 'national sovereignty' in Europe in fact lead their own nations towards decline. Whether Europe succeeds in creating a real integrated continental scale economy, or retreats into individual country units which are too small to be economically efficient in a modern world economy, will largely determine not only the continent's fate but that of the individual countries within it.

Germany's trade data shows the strength of the forces leading to the creation of a real European continental scale economy. The present parochial state of European politics - increasingly influenced by obsessions about banning minarets, immigrants, discussion of non-existent threats to ' convert Europe to Islam', and other forms of xenophobia and racism - leads the continent and the individual countries within it to decline.

It is a common pattern that a European country reached a peak of power followed by a prolonged period of fall - Italy in the 15th century, Spain in the 16th, Holland in the 17th, Britain in the 18th and 19th. Europe, which for several centuries was the world's most powerful continent, seems on the political level intent on pursuing the same path.

It remains to be seen whether the forces expressed in Germany's continental scale economy, and the parallel processes in other countries, can reverse the processes of decline which are expressing themselves in European politics.

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This article originally appeared on the blog Key Trends in Globalisation.

The myth of the decline of the US consumer - by John Ross

A widespread myth about the international financial crisis is that what is taking place is a serious reduction of consumption in the US, with the knock on consequences that would flow from this for the world economy. The present article shows that this myth is factually untrue. No major downturn of US consumption has taken place. Therefore such a non-existent downturn in US consumption cannot be the driving force of either the US or international ‘Great Recession’.

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The claim that a key driving force of the present international 'Great Recession' is a major downturn of US consumption is a frequent one. We will take as an example of this argument Stephen Roach’s book The Next Asia - all page references therefore refer to this work. Roach, president of Morgan Stanley Asia, is chosen because he is a coherent economist who spells out this mistaken claim more lucidly than many far less serious economists who make it.

According to Stephen Roach what is taking placed is the 'capitulation' of the US consumer. Thus Roach refers to, ‘America’s postbubble compression of consumer demand.’ (p378).

This alleged reduction in US consumption is then cited as the driving force of the economic downturn. As Stephen Roach put it:‘The current recession is all about the coming capitulation of the American consumer.’(p20) Therefore: ‘The main event… is the likely capitulation of the overextended, savings-short, overly indebted American consumer.’(p42). Roach concludes that: ‘After a dozen years of excess, the overextended American consumer is finally tapped out… Hit by the triple whammy of collapsing property values, equity wealth destruction, and an ongoing unemployment shock.’(p325)

As a result of this situation a major reduction in the share of consumer spending in the US economy is foreseen. Stephen Roach concludes: ‘the US consumption share of real GDP, which hit a new record of 72.4% in the first quarter of 2009, needs, at a minimum, to return to its prebubble norm of 67% ... the die is cast for a protracted weakening of the world’s biggest spender.’(p32) The situation is therefore that: ‘the US consumer [is] most likely in the early stages of a multi-year contraction’ (p79) Indeed: ‘Despite the unprecedented contraction of consumption in late 2008, there is good reason to believe the capitulation of the US consumer has only just begun.’ (p385)

It is this alleged reduction of US consumption which, it is asserted, will cause the slowdown in the world economy: ‘The postbubble shakeout stands to be dominated by a protracted adjustment of the US consumer – providing powerful and lasting headwinds on the demand side of the global economy for years to come.' (p396)

The problem for this thesis is that it is factually incorrect. No such major reduction of US consumption has taken place. The share of consumption in US GDP has expanded and not contracted. And, as no significant reduction of US consumption has taken place, it therefore cannot explain any of the current trends in the world economy

To show the factual situation Figure 1 graphs the percentage change in the major components of US GDP between the 2nd quarter of 2008, the last before the US recession began, and the most recent available data - that for the 4th quarter of 2009. During this period US GDP contracted by -1.9%. However the reduction in US personal consumption was only -0.6%. Government expenditure, consumption and investment taken together, increased by 3.1%.

Compared to the relatively small fall in US personal consumption the really large declines were in US residential fixed investment, which dropped by -21.2%, and in US non-residential fixed investment, which declined by -20.3%, In other words, as regards the US domestic economy, what occurred was not a consumer decline but a large investment fall.

As regards the external relations of the US economy there were also declines in exports, down -7.7%, and a major drop in imports - by -12.3%.

Compared to these major shifts in investment and trade the decline in US consumption was extremely small and played almost no role in the economic contraction.

Figure 1

To show the real shifts in the US economy even more starkly, and illustrate further that the 'decline of US consumption' is a myth, Figure 2 shows the shifts in the major components of US GDP from the 2nd quarter of 2008 to the 4th quarter of 2009 in monetary terms - i.e. in current prices.

In this period US GDP fell by -$34 billion. However US personal consumption actually rose by $56 billion. In contrast US residential fixed investment fell by -$129 billion and US non-residential investment dropped by -$362 billion. The total decline in US fixed investment was -$490 billion. The breakdown of these figures is important as it shows that the downturn in investment was concentrated in non-residential, and not simply residential, sectors.

Over the same period inventories rose by $9 billion. Net trade, that is the trade balance, improved by $298 billion. US government expenditure, consumption and investment combined, increased by $92 billion.

In current price terms, therefore, there has been no fall at all in US consumption, indeed it has increased. It is US fixed investment that has fallen sharply.

Figure 2

What has made possible these shifts is that the proportion of the US economy devoted to personal consumption has not fallen, as Stephen Roach and others believed it would, but it has on the contrary increased. This is shown in Figure 3. US personal consumption was 70.3% of GDP in the 2nd quarter of 2008, immediately before the recession started, and it had risen to 70.9% of GDP by the 4th quarter of 2009.

Figure 3

In summary, the claim that the 'Great Recession' is rooted in a decline of the US consumer, and of US consumption, is a myth. No such decline has taken place. The economic decline in the US is a fall in investment, not in consumption.

Theories that the present situation in the world economy is driven by a decline in the US consumer and US consumption are therefore equally false. A process cannot be driven by something which has factually not occurred.

A myth is not made truer by repeating it. Therefore the claim that the 'Great Recession' is rooted in a decline of the US consumer, and US consumption, should be abandoned as factually unfounded.

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This article originally appeared on the blog Key Trends in Globalisation.

Memo to Martin Wolf - India and China show that to maintain support for globalisation reliance on 'trickle down' needs abandoning

In his blog from Davos Martin Wolf, chief economics commentator of the Financial Times, notes: 'I am listening to Lawrence Summers as I write. He has emphasised that we cannot maintain global integration if it is seen as a source of domestic disintegration. This tension - that between the global economy and domestic politics - is a central challenge of our time. It affects everything we try to do.'

Martin Wolf is a very strong supporter of global economic integration for reasons he set out in Why Globalisation Works and numerous other writings. The danger he warns against is that popular backlashes in favour of protectionism will undermine the process of global economic integration. In the US and a number of European countries popular sentiment in favour of protectionism has increased - although its effect on those who make economic policy, as regards the most important issues, is as yet far more limited.

For slightly different reasons to Martin Wolf this blog is also strongly in favour of the process of global economic integration and against protectionism. The reason for this is that division of labour, followed by investment, is the most powerful force in economic growth and in the modern era participation in increasing division of labour is necessarily international in scope. Preventing popular, indeed any, backlashes in favour of protectionism is therefore an important question.

In dealing with this issue Martin Wolf could reflect on the difference in sentiment between India and China on the one hand and the US and Europe on the other. In India a government pledged to take the country down the strategic path of integration in the international economy was re-elected with a convincing mandate. In China, as anyone who visits the country knows, popular support for the 'opening up process' (official terminology for the country's orientation towards globalisation) remains high. The contrast in popular mood between India and China on the one hand and the US and Europe on the other is therefore striking.

Part of this difference is, of course, the much more rapid growth of India's and China's economies compared to Europe and the US. However, simply rapid growth is not sufficient to maintain popular support for international economic integration - and while the US and European economies have been expanding less rapidly than India and China they were, prior to the current recession, still growing.

The former BJP government in India achieved rapid economic growth but was tossed out of office by the electorate. Entirely rationally the population will not support globalisation if this merely yields higher GDP figures recorded in statistical works,. They will support globalisation only if it delivers better living standards for them. The majority of India's population considered the BJP's rapid economic growth had not delivered for them and therefore voted against the government.

The strategic concept of the new Congress government under Manmohan Singh was, and remains, 'inclusive growth'. It aimed at rapid growth, using global economic integration as a key means to achieve this, but did not rely on 'trickle down' to make sure the mass of the population shared in its benefits. Conscious programmes of redistribution of resources to rural areas, and less well off sections of the population, were part of the bedrock of 'inclusive growth'.

It is also notable in China that Hu Jintao's 'harmonious society' has included direct measures to redistribute the benefits of growth to those who were not previously perceived as having gained sufficiently. In China's stimulus package to confront the international financial crises, price reductions on consumer durables were targeted on rural areas, the government has reintroduced free education, a major expansion of the health care system is taking place, large scale investment is taking place in the less well off inland provinces etc.

In short, both India and China have abandoned 'trickle down' as the method of ensuring all share in the growth produced by international economic integration.

In the US and Europe, on the contrary, the movement has been towards greater reliance on unfettered free markets. The evidence shows, however, that unfettered operation of the market increases inequality sharply. The most notable result of this is that median wages in the US have relatively stagnated for two decades at the same time as relatively sustained economic growth occurred - it is necessary to look no further than this to understand populist backlashes in the US. In the US the gap in income and wealth between the bottom and top of society has widened greatly, as it has in Britain. The US and Britain by relying on 'trickle down', by the operation of the free market, have therefore sharply increased inequality - and, in the case of the US, deterioration of the economic situation for significant layers of the population has occurred.

India and China, in short, have abandoned 'tickle down' while the US and Europe have embraced it. In India and China support for strategic global economic integration remains high. In the US and Europe a backlash against it has developed.

Martin Wolf, in his entirely justified argument against the US and Europe embarking on protectionism, can therefore consider the contrast in the popular mood in India and China. It may indicate why, to maintain popular support for globalisation, the US and Europe also need to abandon reliance on 'trickle down'.

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This article originally appeared on the blog Key Trends in Globalisation.

The real reason global imbalances have declined - factual economic trends in the US and China

One of the most publicised theories regarding the current state of the world economy, and the causes of the international financial crisis, is that regarding 'global imbalances'. This thesis has been presented at book length by Martin Wolf in Fixing Global Finance, as well as in numerous articles in his position as the Financial Times chief economics commentator, by Stephen Green of Standard Chartered, by David Cohen of Action Economics, by Brad Setser, by Michael Pettis, Professor of Finance in Peking University, and numerous other authors.[1]

This theory has however been described as erroneous by Asian leaders. That they are right in this opinion will be shown below. Specifically there is a logical incoherence in the theory in that its policy prescriptions are not entailed by its analysis. This in turn leads to it not being in accord with the facts of the world economy as the global imbalances it describes are shrinking by quite other mechanisms than the ones it outlines. As a result it is wrong in its policy proposals - as shown by the fact that the most rapid economic growth is being enjoyed by an economy, China, which is pursuing policies which are the opposite of those prescribed by this theory.

A theory which is deficient in coherence, and which fails to foresee the possibility of reducing global imbalances by mechanisms which are actually occurring, is evidently a theory which is erroneous.

Given the wide range of those supporting variants of what will be termed the 'global imbalances hypothesis' this theory naturally has a number of secondary variations. But they have a common core consisting of an analysis coupled with a policy conclusion which it is alleged is entailed by it.

On this theory, the well known problems of the US financial system are outward signs of a much more fundamental malaise of imbalances in the world economy. In the words of Martin Wolf: 'Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter…. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn.'

The core analysis of this theory is that the world economy has been characterised by two global imbalances, the first being the US balance of payments deficit – ascribed to US lack of saving/over consuming, the second being China's balance of payments surplus – allegedly caused by China 'over saving'. The policy conclusion which allegedly follows from this is that the US save more and China save less.

As Brad Setser put it: 'the global economy prior to the crisis was characterized both by high levels of both savings and investment in Asia and the oil exporters and by high levels of consumption and low levels of savings in the US. 'Therefore, as Robert Skidelsky phrased it: 'emerging market economies need to spend more and save less, and mature market economies need to spend less and save more.'. As Martin Wolf put it specifically regarding China: ''does it make sense for China to save so much or, for that matter, to invest so much?... Higher consumption today would surely be desirable.'

It is unclear in some variants whether this theory is being put forward merely prescriptively or whether it is stated that the trends it proposes as desirable are actually occurring – or a combination of the two. However it is clear that a number of its supporters believe that the proposed policy prescriptions of this theory are actually occurring. Thus for example Robert Skidelsky argued in July: 'In fact the present financial meltdown is producing the market-led adjustment that has eluded policy makers. Willy-nilly Americans are having to spend less and save more.'

The 'global imbalances hypothesis' has become so prevalent it may be described, in the phrase popularised by JK Galbraith, as a 'conventional wisdom'. Unfortunately, like many other previous conventional wisdoms it is not true. There are a number of further aspects of the 'global imbalances hypothesis' which are wrong, and which have earlier been analysed on this blog. But if a theory, as will be shown, is inconsistent and factually wrong that constitutes adequate grounds why it should not be maintained. A new, more correct, conventional wisdom is required.

Inconsistency of the theory

The economic inconsistency of the 'global imbalance hypothesis', that is that the policy prescription does not logically follow from the analysis, is easily demonstrated. A country's balance of payments is, by basic accounting identity, equal to the difference between its domestic savings and its domestic investment - the US deficit is exactly equivalent to the degree that US savings are lower than its domestic investment, China's surplus is exactly equivalent to the degree that its savings are higher than its domestic investment.

It immediately follows from this identity that the only way to correct such imbalances, if that is set as the overriding goal of policy, is not at all, as the 'global imbalances hypothesis' suggests, for the US to save more and China to save less. It is equally possible to solve these imbalances, again if this is set as the policy goal , by the US investing less and China investing more. Furthermore it is this latter process affecting investment, not the ones foreseen by the 'global imbalances hypothesis', that is actually occurring and leading to the lessening of the global imbalances.

To take this in detail, factually global imbalances are indeed rapidly declining – the US balance of payments deficit is shrinking and China's balance of payments surplus is declining. But they are doing so for reasons that are the the opposite to those outlined in the theory above.

Far from US saving rising it is declining. The US balance of payments deficit is therefore not shrinking because US saving is rising but because US investment is falling even more rapidly than US saving. China's balance of payments deficit is not declining primarily because it is consuming more but because it is investing more – that is, because China is moving its investment level up to its savings level, and in so doing generating the most rapid rate of growth in the world.

These factual trends have previously been outlined both regarding the US and China on this blog. The latest data which allows a major testing of the different theories is the publication of the second quarter US GDP figures together with data for the equivalent period for China's trade and GDP. All US data below therefore, unless specifically stated otherwise, is calculated from the tables accompanying the US second quarter 2009 GDP figures published by the US Bureau of Economic Analysis. The data shows clearly that the trends taking place in the world's two largest economies are not those in the 'global imbalances hypothesis'.

The rise in US consumption

Taking first the fundamental trend in US consumption, it is clear that under the impact of the international financial crisis US consumption has not fallen but risen further as a percentage of GDP. This is shown in Figure 1.

As may be seen total US consumption, the sum of personal and government consumption, rose rapidly as a proportion of GDP from 1997 until the end of 2003, then stabilised until the end of 2007, and then began to rise sharply again from the beginning of 2008 under the impact of the developing financial crisis.

Figure 1

Taking precise figures, between the last quarter of 2007 and the second quarter of 2009 US consumption rose from 85.8% of GDP to 87.6% - an increase of 1.8% of GDP. Between the second quarter of 2008, the last before the opening of the entirely open financial crisis with the collapse of Lehman's, and the second quarter of 2009 US consumption rose from 87.0% to 87.6% of GDP. Between the first and second quarters of 2009 US total consumption rose from 87.2% to 87.6% of GDP. The trend of rising US consumption under the impact of the financial crisis is therefore clear. More detailed breakdown of this rising share of consumption in US GDP may be found in the footnote. [2]

If US consumption has risen as proportion of GDP why, therefore, has the US balance of payments deficit been shrinking? By accounting identity this deficit is necessarily equal to the shortfall of US savings compared to domestic investment. Therefore shrinkage of the deficit means the gap between saving and investment is narrowing despite consumption rising. The explanation is that US savings are not increasing but falling, but US investment is falling even more rapidly than US saving.

The decline in US investment and saving

Analysing first investment, for which the necessary detailed data is available in the US second quarter GDP figures, these show that US total investment fell between the fourth quarter of 2007 and the second quarter of 2009 from 19.1% of GDP to 14.8% - a decline of 4.3% of GDP.[3] In the period between the second quarter of 2008 and the second quarter of 2009 US investment fell from 18.3% to 14.8% of GDP.

Turning to savings, ideally one would wish to have direct measurement of total savings for the second quarter of 2009, which were not published with the GDP figures, and figures for the US balance of payments for the same period – which are also not yet published. Fortunately, however, the shifts in the US trade balance are so large that it is relatively easy to work out the trends.

Savings equal the sum of total investment, for which full US figures are available, minus the balance of payments deficit – for which second quarter figures are not yet available. But shifts in the US balance of payments are dominated by changes in the trade balance. Provided, therefore, that it is being used to establish a qualitative direction of change, and is not projected as an exact statistical calculation, it is perfectly possible to use the major shift in the US trade balance to show the change in the direction of US savings.

If 2008 is taken as the year in which the financial crisis unfolded then the US balance on trade in goods and services fell between the last quarter of 2007 and the second quarter of 2009 from 4.9% of GDP to 2.5% - an improvement of 2.4% of GDP (see Figure 2).

Figure 2

It follows from the data above that US investment has fallen by 4.3% of GDP since the beginning of the financial crisis while the US balance of trade has improved by only 2.4% of GDP - a difference of 1.9% of GDP. If all other components of the balance of payments had remained the same then this would necessarily mean that US savings had also declined by 1.9% of GDP – if savings had remained static, and other components of the US balance of payments had remained constant, then a 4.3% of GDP fall in investment would have translated into a an equivalent 4.3% improvement in the balance of payments figures. The 1.9% of GDP gap between the 4.3% decline in investment and a 2.4% fall in the balance of payments would necessarily mean that US savings had fallen by 1.9% of GDP.

Evidently no such precise quantitative assertion can be made as what is being calculated above is the trade balance and not the overall balance of payments. But it means that for US savings not to have fallen components of the US balance of payments other than trade would have had to improved by 1.9% of GDP or $269 billion. This is completely implausible and it is therefore evident that US savings have been falling.

This is confirmed by taking the latest figures for which there is measured data on total savings, that is for the first quarter of 2009. Between the fourth quarter of 2007 and the first quarter of 2009, US total savings fell from 13.9% of GDP to 11.5% of GDP. These trends of falling US savings are shown in Figure 3.

Figure 3

The reason some media commentators have claimed US saving is rising, when it is actually falling, is because they confuse household saving (which rose from 1.1% of GDP to 4.0% of GDP between the last quarter of 2007 and the second quarter of 2009) with total saving (the sum of household, company and government saving). The rise in US personal saving is however being more than offset by the decline in company and government saving – hardly surprising given the scale of the US budget deficit. Robert Skidelsky's statement, cited above, that US saving is rising is therefore inaccurate - it appears he may be making an incorrect generalisation from personal saving to total saving.

Michael Pettis claims that US consumption is falling more rapidly than GDP, which would imply saving is rising, but unfortunately makes two errors – first he confuses personal consumption with total consumption, and second he fails to note that shifts in relative prices mean that although in volume terms US personal consumption fell more rapidly than GDP in the second quarter of 2009 it increased as a percentage of GDP. From the point of view of global imbalances, that is the US balance of payments deficit, it is the proportion of GDP devoted to consumption which is determining and not movements in volume.

It is therefore clear that the first part of the 'global imbalances hypothesis' regarding the US is wrong. The imbalance of the US balance of payments deficit is not falling because US saving is rising but because US investment is falling even more rapidly than US saving is falling. Now consider China.

China's rising investment and declining trade surplus

While the macro-economic data available for China for the second quarter of 2009 is not as detailed as for the US nevertheless, again, the shifts are so large it is relatively easy to ascertain the trends.

The first trend is that China's investment is rising as a percentage of GDP. Second China's balance of payments deficit is declining. These will be considered in that order.

First, taking the rise in China's investment as a percentage of GDP, the components of the 7.1% rise in GDP in the first half of 2009 were 6.2% rise in investment, 3.8% rise in consumption, and minus 2.9% fall in net exports. Unless China's savings were increasing equivalently such a rise in the percentage of investment in the economy necessarily means that China's balance of payments surplus must fall.

As with the US balance of payments figures for China for the second quarter of 2009 are not yet available. But the drop in the trade surplus, which dominates China's balance of payments position, is of sufficient magnitude that it is clear that China's balance of payment surplus is falling.

Figure 4 shows China’s monthly trade surplus since 1992 up to June 2009. Figure 5 shows the same data calculated as a three monthly moving average in order to avoid any purely short term distortions.

Figure 4

Figure 5

The trend is clear. 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. The surplus for June was $8.25 billion.

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

Shifts in other components of China's balance of payments sufficient to offset the rapid decline in the trade surplus are not credible so it is clear that China's overall balance of payments surplus has shrunk - meaning the gap between China's savings and investment has narrowed.

While savings figures are not available for China at present it is clear from the data above that they have not risen to match China's rise in investment. There are reasons to believe China's savings may have declined somewhat – China's budget is projected to move into a 3% of GDP deficit, profitability of export and other industries is under pressure from the international financial crisis, and given a 15% rise in retail sales there is no reason to believe household saving has risen significantly (if at all).But it is clear that China is fundamentally responding to the financial crisis by raising its rate of investment. The result has been the most rapid rate of growth in the world.

The logical lacunae in the global imbalances hypotheses, that it did not point out that China could just as much reduce its balance of payments surplus by increasing investment as by reducing saving, is therefore the actual course of China's economic policy - with the most successful results of any country in the world.

Indeed it is quite probable that this year, in net terms,the whole of world growth will be accounted for by the expansion of China's economy. Compared to this level of economic success all discussion of 'green shoots' in other economies is insignificant.

The errors of the 'global imbalances hypothesis'

For the reasons set out above it is therefore not material that the 'global imbalances hypothesis' is conventional wisdom - many things that are conventional wisdom turn out to be false, nor that a number of those supporting it are outstanding economists, nor that Martin Wolf is one of the world's outstanding economic journalists with a deep knowledge of economic statistics etc. A theory which lacks internal coherence, which is factually wrong, and which leads to wrong policy prescriptions is a theory that does not meet the test of scientific rationality. It should therefore be set aside.

Instead the realities of the world economy should be recognised. The US balance of payments deficit has been shrinking not because US saving has been rising but because US investment has been declining more rapidly than US saving has been falling. China's balance of payments surplus has been declining primarily because its investment level has been rising. That is, the logical gap which existed in the 'global imbalances hypothesis' corresponds to the actual course taken by the world economy. As always when the facts and a theory do no coincide it is the theory which should give way.

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This article by John Ross originally appeared on the blog Key Trends in Globalisation.

Notes

[1] The wide circulation of this analysis may be traced to a speech by Ben Bernanke, now Chairman of the Federal Reserve,

[2] Breaking these figures down into their detailed components US personal consumption rose from 69,9% of GDP to 70.6% between the fourth quarter of 2007 and the second quarter of 2009. In the period from the second quarter of 2008 to the second quarter of 2009 US personal consumption rose from 70.3% of GDP to 70.6%. US personal consumption increased between the first and second quarters of 2009 from 70.4% of GDP to 70.6%.

To calculate precisely how much US government consumption has risen it is necessary to note that the US is unusual in that in its main aggregate GDP statistics it groups together government consumption and government investment – most countries statistically treat government investment simply under overall investment. If the two components (consumption and investment) of US government expenditure are taken together they increased from 19.2% of GDP in the last quarter of 2007 to 20.7% of GDP in the second quarter of 2009. It is necessary to eliminate from this the rise of government investment from 3.3% of GDP to 3.6% of GDP in the same period. Government consumption rose from 15.9% of GDP to 17.0% of GDP. In the period since the second quarter of 2008 US government consumption has risen from 16.4% to 17.0% of GDP.Government consumption rose from 20.3% to 20.7% of US GDP between the first and second quarters of 2009.

Considering, therefore, both total consumption and its breakdown the rising proportion of consumption in US GDP since the beginning of the financial crisis is clear – indeed consumption has risen as a proportion of US GDP both as regards personal consumption and government consumption.

[3] Private fixed investment declined from 15.8% to 12.3% of GDP, inventories fell from plus 0.1% of GDP to minus 1.1.% of GDP, and government investment rose from 3.3% to 3.6% of GDP.

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.

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

US share price decline continues to match fall after 1929

The latest market shifts confirm that to date in the present financial crisis the fall in US share prices continues to be at a post-1929 rate – see Figure 1.

Figure 1

Last Friday, 27 February, was the 352nd trading day since the all time high of the Dow Jones Industrial Average on 9 October 2007. Since its peak the Dow has declined by 50.1%. On the 352nd trading day following its 1929 high point the Dow had declined by 55.6%. The difference between the falls is within the range of short term fluctuations. Overall the rate of decline of US share prices since October 2007 is tracking the 1929 descent.

As may be seen from Figure 2 the current decline of share prices is far more rapid and deep than either of the other two major falls in the 20th century – that following the oil price increase of 1973 or following the implosion of the dot com share bubble in 2000. These trends confirm again that the only relevant scale of comparison for the current decline of US share prices is with 1929 itself.

Figure 2

The only fundamental difference between the current decline and that of 1929, so far, is the duration of the fall. After 1929 it took the Dow Jones 713 trading days to reach its bottom – the trough being on 8 July 1932 by which time the Dow it had lost 89.2% of its value. It remains to be seen for how long the current decline will continue. However although the duration of the drop is at least as yet not as great as after 1929 it is as rapid.

While the financial collapse is therefore genuinely on a scale to be compared to 1929, the overall declines registered in the productive economy are still far smaller than the post-1929 falls. However the declines in the productive economy have just commenced and data is still coming in. Some drops, such as in trade, are approaching scales seen post-1929. However the decline in US GDP in the 4th quarter, now revised downwards to an annualised decline of 6.2 per cent, is about two thirds of the 9.4 per cent drop in US GDP seen between 1929 and 1930 – however the rate of decline is accelerating.
While quite sufficient information is now in to make clear that the current financial crisis is only comparable to 1929, far exceeding the shifts seen in a normal recession, further data is still required to see whether it will be meaningful to compared the fall in production to that after 1929 or not.

Monthly Review, Venezuela and Socialist Economic Bulletin

Readers of Socialist Economic Bulletin may be interested to know that the website of the US magazine Monthly Review has republished the article from SEB 'Will Keynesianism be enough to halt the investment decline?'
Such international exchange of views is very welcome because co-operation and discussion between socialists in different countries is obviously vital in confronting the international financial crisis.
Another development SEB readers may therefore be interested to know of is that co-operation has been taking place with socialists in Venezuela and a dual language English and Spanish website
La Economía Venezolana - The Venezuelan Economy has been created. This carries specific analysis of the Venezuelan economy as well as some articles which have appeared on SEB.

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.

G20 agree to avoid the main issues - and Britain will be hit

The G20 Washington meeting of the leading economic powers avoided all the main issues that are really driving the international financial crisis.
Adding a fiscal stimulus, via tax cuts and increased government spending, to the measures already announced for taxpayer purchasing of bank shares is like administering a pain killer in an attempt to treat a serious disease. It might, at best, make the patient feel a little better. It does nothing to treat the underlying causes of why they are feeling so bad nor will it prevent the symptoms of the disease breaking out again.
The main driving force of the financial crisis remains that the dollar is overvalued and the US economy is over stretched to an extent that destabilises the world financial system. To stabilise the world economy there must, therefore, be a reduction of expenditure by the US.
The only way this can be achieved, without the US population suffering the consequences of this via drastically reduced personal consumption, is if US military expenditure is drastically reduced - which will involve measures such as withdrawal from Iraq. Refusal to acknowledge such economic realities is why the Bush presidency was such a drastic failure - leading first to an unsuccessful war in Iraq and then a financial disaster. However, so far, the US government shows no serious signs of understanding this lesson and therefore the US population will continue to suffer - along with the rest of the world.
Regarding reform of international financial institutions, a 'new Bretton Woods', the only way the IMF could be strengthened is to increase the voting weight of China, India and other new rapidly growing developing countries - as otherwise they will not give meaningful injections of funds. But that means reducing the role of the US - which, so far, it will not agree to. So there is an impasse on that front.
In Britain, meanwhile, the conditions are accumulating for a new financial storm. While other countries will agree to prop up the dollar temporarily for political reasons no major country sees any reason to prop up the pound. The UK therefore faces, in a more immediate form, the same choice as the US. Given the UK's real purchasing power in international terms will fall, as the pound's exchange rate declines, it will either have to cut military expenditure or reduce the living standard of the population below what is required. A fiscal stimulus of tax cuts and increased public spending will, at best, only delay that choice for a short period - and they will only be able to do that provided financial markets do not rebel. Meanwhile the government faces the immediate dilemma that the price at which it agreed to purchase shares in RBS, HBOS and Lloyd's TSB is in every case now above the market price for the same shares - threatening the taxpayer with substantial loss.
It is even clearer in this situation that only the policies of the left - reduction in UK military spending to avoid attacking the living standards of the population, targeted economic aid to those worst affected by the financial crisis to maintain consumer spending, increased state spending on infrastructure to keep up investment and improve the competivity of the economy - have a realistic way out of this financial crisis. The left's case is not only morally superior it is the only economically rational one - as the G20 meeting vividly illustrated.