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.

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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

China and the international financial crisis

China's reaction to the international financial crisis will play a crucial role not only for its own but for the world economy. However, seen from China's perspective, the international financial crisis has features which differ significantly from those in Europe or the US. This post looks at some of these.
The first point is that in confronting the international financial crisis direct financial turmoil is not a key feature of the situation in China - unlike the spectacular manifestations of this seen in Europe or the US. China's banks had almost no exposure to now heavily discounted, or worthless, sub-prime mortgage or similar financial products. While in Hong Kong there is some concern over the direct financial fallout, no mainland Chinese bank has suffered significant losses in this field. The immediate issue for China is the effect on its productive economy and on the renminbi’s exchange rate. But underlying these is a still more fundamental issue – maintenance of China’s savings and investment rates.
Indeed. seen from China, the international financial crisis might be posed from a different angle. It may be viewed as the 'third great Asian financial crisis' – the first being that of Japan and the yen in 1973-90, and the second that of the South East Asian debt and currency crisis of 1997. To emerge successfully will require from China an enormous response and a new stage of its economic development.
Socialist Economic Bulletin has noted that the fundamental determinant of the much higher rates of growth of a number of Asian economies, compared to the US or Europe, is their far higher investment rates. Therefore for the US and Europe to regain competitiveness with Asia one of two things has to happen. The US and Europe have to raise their investment rates up to Asian levels, or the Asian economies have to lower their investment rates down to US and European ones.
These two courses have very different implications for world economic growth. If the US and Europe raise their investment levels towards Asian ones then Asia will essentially maintain its present economic growth rate and that of the US and Europe will increase – i.e. world economic growth will accelerate. If, however, Asian investment levels are reduced towards US and European levels then the growth rate of the Asian economies will also fall, while economic growth in the US and Europe will not increase – i.e. world economic growth will decline. It is, therefore, far preferable that the US and Europe increase their investment rates rather than that those in Asia fall.
Nevertheless, in successive economic crises of the last thirty years, the outcome was the opposite of the preferable one – the US and Europe did not increase their investment rates, indeed those in Europe fell, but the investment rates of a number of Asian economies declined.
To illustrate this process in more detail, Figure 1 shows the level of fixed investment as a percentage of GDP for the US, Germany and France. As may be seen, the US fixed investment level has been essentially constant for the last half century at around 20 per cent of GDP – itself a continuation of a very long term trend in US investment rates. The German and French levels were somewhat higher than that for the US for the period up to the early 1970s, at around 25 per cent of GDP, and then fell to levels comparable to the US. Such investment levels generate rates of growth of 1.5-3.5 per cent a year.

Figure 1

If these US and European trends are compared to the situation in Asia there is a clear contrast. Asian economies have achieved far higher levels of investment, reaching over 40 per cent of GDP, and far higher rates of growth – in some case approaching or achieving double digit rates. However, the effect of both the post-1973 crisis in Japan, and the 1997 crisis in South East Asia, was to reduce these investment rates and with them also rates of growth of growth of GDP.
Considering this trend in a number of Asian countries in greater detail, Figure 2 shows the proportion of GDP accounted for by gross fixed capital formation in Japan. Japan’s fixed investment level peaked at 36.4 per cent of GDP in 1973. At this time, averaging the preceding five years, the annual average rate of growth of Japan’s GDP growth was 9.3 per cent.

Figure 2

The economic events which commenced in 1973, and which were accompanied by the first ‘oil shock', greatly affected Japan. The proportion of GDP devoted to gross domestic fixed capital formation declined to 27.5 per cent by 1986, and Japan’s average annual rate of growth of GDP, over the preceding five years, fell by two thirds to 3.1 per cent. By 1986 the Japanese economy, which had been expanding almost three times as fast as the US in the early 1970s, was growing more slowly than the US – in comparison in 1986 the average annual growth rate of US GDP over the preceding five years was 3.5 per cent.
Japan’s investment rate then temporarily rose under the impact of the hyper lax monetary regime during the ‘bubble’ economy in the late 1980s – a consequence of Japanese financial policies introduced to aid US economic stability following the 1987 Wall Street stock market crash. Following the bursting of Japan's financial bubble in 1990, the investment rate fell again and by 2002 gross domestic fixed capital formation had declined to 25.8 per cent of GDP while Japan’s five yearly annual growth rate of GDP had declined to 0.2 per cent.
Summarising these processes, under the successive impacts of the oil price increase and the monetary effects in Japan of the measures it chose to take to respond to the 1987 Wall Street crash, the proportion of the Japanese economy devoted to fixed investment fell by 10.6 per cent of GDP, and Japan’s annual growth rate decelerated from 9.3 per cent to 0.2 per cent - a 98 per cent decline.
If Japan post-1973 was the first great Asian economic/financial crisis, the second was the debt and currency crisis of the South East Asian economies in 1997. The similarity of the outcome to the earlier crisis in Japan’s is striking.
Figure 3 therefore shows South Korea’s rate of gross domestic fixed capital formation. This rose progressively to 39.0 per cent of GDP in 1991. By that year the average annual rate of growth of South Korea’s GDP over the preceding five years was 9.4 per cent.
By 1996, the last year before the currency crisis, South Korea was still investing 37.5 per cent of GDP and its five yearly annual average rate of growth of GDP was 7.3 per cent.
Following the 1997 debt and currency crisis, however, the proportion of South Korea’s GDP devoted to fixed investment fell sharply, to only 28.8 per cent of GDP in 2007, and its five yearly annual average growth rate of GDP declined by almost half to 4.4 per cent.

Figure 3

Figure 4 shows the similar process in Thailand. By 1996 the proportion of Thailand’s GDP devoted to fixed investment was 41.1 per cent of GDP – although this level was clearly unsustainable as it far exceeded the domestic savings available to finance it, resulting in a balance of payments deficit of 8.2 per cent of GDP. Thailand’s five yearly average annual rate of GDP growth was 8.1 per cent.
Following the currency crisis, by 2007 the proportion of Thailand’s GDP devoted to gross domestic fixed capital formation had declined to 26.8 per cent and the five yearly average annual rate of GDP growth had fallen to 5.6 per cent.

Figure 4

Figure 5 shows the similar process in Malaysia. By 1996, the last year before the debt/currency crisis, Malaysia’s gross domestic fixed capital formation was 42.5 per cent of GDP - although again this was being unsustainably financed by a balance of payments deficit. Malaysia’s five yearly annual average rate of growth of GDP was 9.6 per cent.
By 2007, ten years after the currency crisis, the proportion of Malaysia’s economy devoted to fixed investment had fallen to 21.7 per cent and the five yearly average annual rate of growth had dropped to 6.0 per cent.

Figure 5

Therefore, although the mechanisms of the crises were different, the outcomes in Japan in 1973-90, and South East Asia in 1997, were essentially the same - the proportion of the economy devoted to investment fell drastically and therefore so did the growth rate.
The impact of these two previous Asian economic crises, therefore, clearly illustrates the challenge facing China. China’s level of investment is significantly higher than Japan’s in 1973 – China's fixed investment rate is over 40 per cent of GDP compared to Japan's 30-35 per cent at that time. China's annual average annual rate of growth for the last five years is over ten per cent compared to Japan's nine per cent in 1973. In a number of South East Asian states, on the eve of the 1997 crisis, their very high investment rates were unsustainable, as they far exceeded domestic savings levels and were financed through extremely high balance of payments deficits. In contrast China’s savings level, running at over 50 per cent of GDP at nominal exchange rates, is even higher than its level of investment – see Figure 6. China, therefore, does not fact the international financial constraints facing South East Asia in 1997. There is, therefore, nothing inherently financially unsustainable in China’s very high investment rates. It has more than adequate domestic savings to finance its current investment levels and, therefore, approximately its present growth rate.

Figure 6

But it is the international context that has changed significantly and poses the economic challenge. With many economies moving into recession, and virtually all slowing, China's export growth will become significantly harder - even more so as simultaneously the renminbi is becoming a ‘hard’ currency.
As illustrated in Figure 7, the renminbi's exchange rate moved up against the dollar prior to the outbreak of the international financial crisis and it has remained constant against the dollar since its onset. As, however, the dollar has moved up against almost all currencies, except the yen, this means that the renminbi has undergone an upward revaluation against almost all other currencies.

Figure 7

China’s exporters, therefore, face a double squeeze. First, the markets in the economies into which they are exporting are either contracting or growing far more slowly. Second, the renminbi’s exchange rate is rising. This combination squeezes China’s exporters while simultaneously cheapening imports. China's balance of payments surplus may, therefore, decrease from its current level – the last available data being for 2007 showing a surplus of $372 billion.
However, statistically, the balance of payments is necessarily equal to the difference between domestic savings and investment - China’s balance of payments surplus reflecting that its savings level is even higher than its investment level. If China’s balance of payments surplus declines this can therefore only be achieved by its investment level moving up towards its savings level or its savings level declining towards its investment level, or a combination of the two.
Which of these two occurs will have a huge influence on both the Chinese and the world economies. As already noted, in the case of both Japan and the South East Asian economies, faced with crisis, investment levels fell. Their economies consequently drastically decelerated – negatively influencing the rate of growth of the world economy. A major deceleration of China’s economy, particularly under conditions of recession in other major economies, would have very negative consequences for international growth.
The health of the world economy, therefore, requires that if China’s balance of payments surplus is to shrink this should be by moving its domestic investment rate up towards its savings rate, not by its savings level falling towards its investment rate.
Domestic economic requirements China push in the same direction. The exchange rate of the renminbi has not merely moved upwards but will remain higher due to the underlying strength of China’s economy. A clear lesson of the current crisis is that any primary use of China’s financial resources not for domestic investment but fundamentally to attempt to maintain a low exchange rate of the renminbi will not work as a strategy – even in cases where the renminbi is stabilised against the dollar it moves up against other currencies.
China will, therefore, have to learn to compete at a higher exchange rate. This requires that its whole economic mechanism become more efficient, which can only be achieved through investment. China will cease to compete as a pure low wage economy – Vietnam and other economies now occupy the place China did twenty years ago. High levels of investment are therefore vital if China's economy is to compete in this new context.
Put in other terms, China's traditional strategy has been to keep its currency's exchange rate down to the level of productivity of its economy. In the future China will have to raise the level of productivity of its economy up to its appreciating exchange rate - requiring gigantic further investment in its productive base.
Consequently the cyclical requirements of economic management, that is ‘Keynesian’ anti-recessionary measures, coincide with the structural requirements of a high investment level. So far the Chinese government is heading in the right direction in announcing successive waves of infrastructure and other investment – railways, roads, housing. The fact that China has a large state owned economic sector allows it to take far more direct ‘Keynesian’ measure to sustain investment than are available in the US or Europe.
Nevertheless the scales of the programme’s which are required are gigantic. If, to take a hypothetical example, China’s balance of payments surplus were to fall by half under the impact of pressure on exporters and cheaper imports due to the higher exchange rate, while its savings level remained the same, this would required $175-$200 billion extra a year investment in China’s domestic economy. While there is no financial constraint on this, due to the high savings rate, the task of physically gearing up the economy for such a scale of extra-investment programmes is gigantic.
Naturally this particular example is arbitrary, and China’s balance of payments surplus may not fall to this degree, but it shows the scale of economic forces and shifts which are involved.
At the same time China faces new economic challenges it has not experienced previously. The fact that China is acquiring a 'harder' currency will undoubtedly lead to central banks of other countries wishing to hold the renminbi as part of their foreign exchange reserves – an issue China has not faced on a significant scale before.
Simultaneously China will come under pressure to use its financial resources for measures other than investment in its domestic economy. The US has announced that it is arranging dollar swaps for four economies that it considers systemically crucial – Brazil, Mexico, Singapore, and South Korea. But there will be a whole series of much weaker economies in deep trouble and it will undoubtedly be proposed that China should finance these, probably via intermediaries such as the IMF, rather than investing its resources in its domestic economy. When China attends the international economic summit in Washington on 15 November the US will also almost certainly propose that China accelerate a programme of buying US Treasury bonds.
So far China is rightly adopting the approach that 'the most important task for us now is to manage our own affairs well', as vice-premier Wang Qishan put it. But pressure put on China to change that stance, and divert resources away from its key goals, will increase. In other words many other people also have their eye on the funds which China could invest in its domestic economy.
With all these pressures, together with domestic programmes of improving social welfare and attempts to improve conditions in rural areas taking place simultaneously, not to mention other issues to manage, Chinese economic policy makers are going to be kept extremely busy in the coming months.
However, as noted, while there are many specific issues to tackle they are all within the framework of one decisive strategic choice. If China responds in the same way that Japan did in 1973-90, and South East Asia did in 1997, that is by reducing its savings and its investment levels, this will be bad not only for the Chinese economy but for the world economy. If, however, China is able to maintain its savings and investment levels through the present ‘third’ Asian currency crisis, which is a crucial aspect of how the international financial crisis appears from its perspective, not only will that be good for the world economy but it will be one of the greatest pieces of macro-economic management, not to speak of practical management of huge investment programmes, ever seen.
China since 1979 has achieved one of the greatest economic miracles in history. Confronted with the third great Asian financial crisis China again faces a gigantic challenge to its macro-economic management. How successfully it confronts that will have profound consequences not only for its own but for the entire world economy.

Note:
This article is adapted from one that appeared on the blog Key Trends in Globalisation.

Update 10 November:
China has announced a further large scale stimulus package.

Obama's key decision

Anyone with an ounce of humanity or progressive spirit will be lifted by the election of Barack Obama as president of the United States. For the majority of the world's population it will be something far more than that. Anyone who has studied the history of racism in the US knows that for a black person to become president, to assume the most powerful job in the world, is truly an historic moment which it is very difficult to overestimate.
But Barack Obama is also being handed a poisoned chalice - although, perhaps, only in a moment of such turmoil could such an historic shift take place. Obama will inherit the worst financial crisis in the US for eighty years. This crisis is ultimately due to the fact that, due to decades of underinvestment in its domestic economy, the US is simply not competitive at anything like approaching the current exchange rate of the dollar.
For almost thirty years US presidents have attempted to overcome the consequences of this through using the military and political might of the US, which is very real, to substitute for an economy which, except in certain areas of high tech, simply cannot compete. Invading Iraq to seize oil, putting the squeeze on Japan to prop up the dollar at the expense of nearly two decades of Japanese economic stagnation, these were the types of methods used by US presidents to try to avoid the consequences of US economic decline.
Not merely did such methods not work, the economy proved in the long run more powerful as a factor than politics, but they led their country to military and financial catastrophe. George W Bush will be remembered as one of the worst of all US president's for having led his country both to a military debacle in Iraq and then financial disaster in the credit crisis. The neo-con agenda failed at each crucial point.
The only conclusion that can be drawn is that the US must withdraw from these disastrous policies to concentrate its resources on rebuilding its domestic economy. Pull out of Iraq, close the string of the US bases round the world, stop the reckless anti-ballistic missile programmes that destabilise Europe, spend all the resources released on rebuilding the US's infrastructure, improving its schools, and increasing its rate of investment.
If Barack Obama goes down that road he will be remembered not only as an historic president of the United States but as one the greatest presidents of the United States. If he does not follow it, if the continues with the policies of the last thirty years, even the gigantic goodwill he receives as president cannot solve the problems of the US. And that goodwill will dissipate while the racists will proclaim 'we told you so'.
Huge decisions await the new US president. Today every progressive spirit in the world will feel lifted. Very soon will come momentous decisions.

Japan tries to come to the aid of the US

For the first time this week a foreign country with substantial resources decisively and openly came to the aid of the US in the current financial crisis.
Scared by the rise in the exchange rate of the yen, which was threatening to seriously cut into the competivity and profits of Japan's export industries, the Japanese government openly moved. It was widely leaked that Japanese interest rates, already only at 0.5 per cent, would be cut to 0.25 per cent. Simultaneously the Japanese central bank began to sell yen, and more importantly to buy dollars, in order to try to drive down the yen's exchange rate.
The two moves opened the taps to Japanese money to flow into dollars and the US.
Japan is the country with the second heaviest financial artillery in the world to aid the United States. Its current account surplus is $197 billion a year and it has $997 billion in foreign exchange reserves. Only China, with a $372 billion balance of payments surplus and $1,905 billion in foreign exchange reserves, has greater financial firepower.
This means two considerable resources are now being deployed to attempt to shore up the US banking system. The first is the heavy burden, a major transfer of resources away from US taxpayers, i.e. ordinary people, which is involved in the Paulson bank bail out plan. Now Japan has joined in.
Japan's willingness to give open aid is, of course, a serious addition to US resources to meet the crisis and accounts for the sharp share rises on Wall Street.
Two issues are however still posed.
First, will even the combination of squeezing US taxpayers and Japanese aid be enough to stabilise the US financial system? At least at present the answer is that the situation within the US financial system is stabilised but at the expense of more peripheral parts of the world economic system having the financial blood squeezed out of them.
Second, what will be the consequences in Japan itself? The last time Japan was squeezed to aid the US was after the 1987 Wall Street crash. The reason the US economy was fairly easily stabilised following that crash was that Japan gave aid - in the form of a super lax interest and credit rate policy. The result was Japan's late 1980s bubble economy followed by a now 18 year long share market and property market crash and depression that followed from 1990. It will be interesting to see the price Japan will be forced to pay this time.

Nikkei tests historic low - a warning on the UK government's bank share purchase plan

Socialist Economic Bulletin has pointed out the danger to the taxpayer, in the proposed government bank bail out plans, of any assumption that share prices have reached a low.
SEB wrote: 'One of the erroneous aspects of media coverage of the government’s plan for the banks is that it frequently implicitly assumes that bank share prices in the future must rise... This leads to wrong evaluation of risk. If bank shares must inevitably rise, after a period of falls that has already taken place, then there is evidently no significant risk for the taxpayer in buying them. If, however, bank shares may fall further, and remain depressed for a prolonged period, then the risk is very great... the assumption of considerable risk... by the government in purchasing shares in RBS [Royal Bank of Scotland], HBOS and Lloyds TSB, rather than standing entirely willing to take over the orderly and guaranteed running of these companies if they prove unviable, is therefore not justified.'
This warning was strongly confirmed by events on the Japanese stockmarket today as these demonstrate the risk of further falls and potential depression in share prices.
The Nikkei fell by a further 9.6 per cent, moving down towards the lowest level since the Japanese stockmarket crash started at the beginning of trading in 1990 - see the graph below.
The Nikkei's previous low, since the share market crash of 1989, was on 28 April 2003 at 7606.88. The Nikkei closed on 24 October at 8749.08 - only 0.5 per cent above the April 2003 figure.
If the Nikkei were to fall below its 28 April 2003 level it would be at a 26 year low. Already the Nikkei has been below its peak for almost 18 years.
As SEB has warned any assumption that shares are being bought in RBS, HBOS and Lloyd TSB 'at the bottom of the market' is therefore not justified. At lunch time today the claim of the Radio 4 lunch time news was that if the government had bought shares in RBS, HBOS, and Lloyds TSB at the agreed prices, respectively, of 65.5p, 113.6p and 173.3p the loss to the taxpayer would already have been £5.5 billion.

The US needs a new financial Yalta - will it get one?

The announcement that the US is to host a conference of 20 leading economic powers on 15 November, after the presidential election, shows once more the close interrelation between economic developments in the United States and the international situation.
The huge bank bailout packages that have been announced, amounting to over $2.5 trillion, or approaching 10 per cent of the GDP of the US and Europe, have temporarily succeeded in preventing the complete break down of the interbank lending market - that is, they have headed off the equivalent of a simultaneous heart attack and stroke. But they have done so only by diverting huge quantities of resources into the core of the financial system, and therefore by threatening to cut off the flow to other sections. By these means the patient has survived the first attack but will gangrene set in in areas where the blood supply is no longer operating properly? Will weaker companies, weaker countries, new areas of potential financial problems, go down - struck with shortage of the financial blood supply, that is inability to obtain funds, or able to obtain them only at interest rates, or with political conditions, that are unacceptable?
The hope is that gradually the whole economic circulatory system will gradually start operating again. But whether it will is not yet clear.
One absolutely certain problem that is coming, however, is the US government budget deficit. This was already going to be over half a trillion dollars next year even before the bail out packages. The figures now being discussed, after the bailouts and with a recession starting. are a trillion or more. How will this be funded? And at what interest rate? Will the US have to rely on its own domestic savers purchasing the necessary Treasury bonds - which implies one, higher, interest rate? Or will foreigners join in? That is crucial for the perspective for the US economy next year and the depth of the coming recession.
If, as seems likely, Barack Obama wins the presidential election this question of whether he can negotiate a new financial Yalta will have to be number one item on his economic agenda.

The Paulson plan and unrest in US politics

Introductory note

Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.

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The $700 billion Paulson plan passed by the US Congress will have only a marginal effect on the international financial crisis. It will however have a profound effect on US politics – reinforcing the trend to an era of greater US political turbulence.
The reason the Paulson package will have no major effect on the financial crisis is easily grasped – it is simply too small to be decisive. $700 billion may sound a large sum, but it is small compared to the size of the markets it is seeking to stabilise.
To put arithmetic to this, the $700 billion of the Paulson package may be measured against the $393,000 billion in financial contracts outstanding at the end of 2007. Many such contracts, of course, merely offset each other, and while this sum indicates the weight and complexity of these markets it is not a net figure. However, the issue driving the financial situation, the crisis in US housing mortgages, is a net lending market of $12,000 billion. The entire Paulson package is therefore not only small when compared to the scale of US financial markets but equivalent to only a six per cent fall in US house prices - and a further six per cent fall in US house prices is not merely possible but even likely.
It is the falling prices of the assets, such as housing debt, held by financial institutions that is the transmission belt to the present fulcrum on the crisis – the sharply deteriorating situation in the interbank lending market illustrated in Figure 1.

Figure 1

The vertiginous rise in interbank lending rates that may be seen during September reflects the market's anticipation of high levels of risk of further insolvencies by financial institutions. This risk, leading to fears of a run on the banks, in turn produced the new element of destabilisation – the 100 per cent guarantees on bank deposits introduced by the Irish and Greek governments, which itself produces a move of assets into the institutions covered by such guarantees and out of those of other countries. In effect Ireland and Greece are avoiding a run on their own banks by producing a run on other countries banks.
The prospect of the passage of the Paulson package totally failed to reverse the interbank lending crisis, simply because it is far too small. In the short term only the state can temporarily sustain the interbank lending markets – by the middle of last week financial firms were going to the Federal Reserve for $409.5 billion in overnight loans and even this led to no downward movement in one or three month interbank lending rates - as may be seen in Figure 1. In the medium term only factors affecting overall US spending power by consumers, government and corporations, and international developments, have sufficient weight to reverse that situation.
But if the financial effects of the Paulson plan will be marginal it will have a deep effect on US politics. The model by which free markets are supposed to operate is that entrepreneurs fairly bear the consequences of both success and risk – if they take the right decisions they profit, if they take the wrong decisions they suffer losses.
This model is supposed to continue to operate even in cases where, for any reason, there has to be widespread state intervention. The reason the rescue of the Swedish banking system in the 1990s has been widely praised in the media, and by economic experts, is because it stuck to this principle. Depositors were safeguarded, but the shareholders of banks that had made wrong decisions shouldered any losses before risk to the taxpayers money that was used to rescue the banking system – that is, tax payers were protected and shareholders took the risk.
The Paulson package stands this on its head. Bad debts will be purchased from banks by up to $700 billion supplied by tax payers. This will improve the situation for shareholders, as they will be relieved of the bad debts, but it is bad for taxpayers - who will be acquiring the worst performing assets. In other words the Paulson plan is the opposite of the Swedish one; shareholders are being protected and taxpayers are taking the risk.
Despite this fundamental feature, if the US financial system were to turn round in the short term then while the Paulson package would be unjust it would not be very serious in its social and electoral consequences. Up to $700 billion of taxpayers money would be spent on bad debts in the short term but then this sum would be returned to tax payers as the purchased assets recovered to better values.
But this is extremely unlikely to happen. As has been noted in previous posts the essence of the present financial crisis is the revaluation downwards of assets priced in dollars. Therefore US taxpayers will not get their money back. As shareholders in distressed US financial institutions will have benefited in the meantime there will therefore be a shift in resources from US taxpayers to various categories of shareholders of distressed financial institutions. This, needless to say, will be unpopular.
This is why the Paulson package will not stabilise financial markets - but it will help sustain unrest in US politics.

This article first appeared as 'The Paulson plan and unrest in US politics' on Key Trends in the World Economy

Fundamental driving forces of the financial crisis

Introductory note

Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.

* * *

It is superfluous to note on this blog that the world economy is passing through the most severe financial crisis since 1929.[1] Its results are also beginning to be well understood: the era of increasing deregulation has ended and instead increased, in the US very large scale, state intervention in the economy has begun.[2]
But what type of crisis is this - which greatly affects what its eventual outcome will be?
The most trivially superficial explanation, put forward in tabloid newspapers and demagogic political speeches, is that this is an extremely severe short term convulsion caused by the activities of ‘financial spivs’ and ‘short sellers’– modern embodiments of the ‘gnomes of Zurich’ denounced by British Prime Minister Harold Wilson in the 1960s, Slightly less superficially it is ascribed to subjective, widespread, miscalculation by financial institutions.[3] A related view is that the fundamental factor is psychology.[4] Therefore, there is a widely asserted view that the key issue is ‘confidence' or 'lack of confidence’.
If any of the above were true then, although the present financial convulsion is severe, the adjustments that will follow will eventually be relatively minor. Once current psychology is reversed, that is ‘confidence is restored’, there can be a return to something approximating the previous situation – doubtless with some individual changes.
Such analyses are false. The present financial crisis is not rooted in psychology or subjective mistakes. It is rooted in long term economic trends. Its roots are therefore objective not subjective. Psychology is not driving the objective economic forces but following them.
The unfolding of the financial crisis does, however, show the importance of considering long term trends, and underlying developments, rather than merely considering short term shifts or individual facts taken out of context - as occurs in many newspaper commentaries. Misunderstanding of the preceding period, through failure to consider the overall situation, inevitably led to confusion regarding present events.
The outcomes, and conclusions regarding the real driving forces of the present financial crisis, will be considered at the end of this article. First, however, the decisive data on the situation will be set out.
The most fundamental cause driving the present financial crisis was dealt with in a previous post on this blog - 'Why Asia will continue to grow more rapidly than the US or Europe'. This showed that the US now lags far behind the key Asian economies in the proportion of its economy which is invested - with a consequent continuing decline in the international competitiveness of the US economy.
This trend can be seen in Figure 1 - which is a simplified form of the graph in the previous post. It shows the investment levels (gross domestic fixed capital formation) as a proportion of GDP in the US, China and India. The US invests only 18-20 percent of its GDP whereas India invests over 30 percent and China more than 40 per cent. Similar, if less striking, graphs would show the same pattern for other key Asian economies. The result is China’s economy is growing at 9-11 percent a year, India’s at 7-9 per cent a year, and the US at only 3 percent a year.

Figure 1

Given this US lag in investment, which is a key factor in competitiveness, the US economy, at any given exchange rate, becomes progressively less competitive over time. Consequently, given this decreasing underlying competitiveness, as long as the US does not raise its investment levels to that of other economies the only way for it to remain competitive is to steadily lower its exchange rate – that is to progressively devalue the dollar.
This declining competitiveness of the US economy is illustrated clearly in Figure 2, showing the US balance of payments. That the US runs a large balance of payments deficit is well known, but this graph shows the phases in the unfolding of that process.

Figure 2

The US balance of payments first began to slide into sharp deficit in the early 1980s - the deficit initially reaching over 3 per cent of GDP by the mid-1980s
There was a short lived recovery in the early 1990s - due to dollar devaluation, recession at the beginning of that decade, and a large one off payment from the Gulf states to finance the first Gulf war.
This short recovery was followed by an even greater US balance of payments deficit after 1991 - which reached a peak of well over 6 per cent of GDP, or over well $700 billion a year, by 2006.
To show this development over a longer period Figure 3 shows net US ‘lending’ to the rest of the world since 1956 – a negative number showing US borrowing from the rest of the world. The deterioration of the competitiveness of the US economy is evident from these trends.

Figure 3

Given that the low US level of investment means the only fundamental mechanism by which it can remain competitive is dollar devaluation therefore Figure 4 shows the long term exchange rate of the dollar against two of the world's three most important non-US currencies, the euro and the yen - comparisons over the same period with the third, the yuan, are not meaningful as until the early 1980s China had an artificially set exchange rate which was not aimed at participation in international trade.

Figure 4

Three clear periods of developments in the US exchange rate are evident.
- From the immediate post-war period to the early 1970s the US maintained fixed exchange rates under the Bretton Woods currency system.
- From 1973 until the mid-1980s, via sharp short term fluctuations, a substantial dollar devaluation took place.
- From the mid 1980s onwards, while there were considerable short term fluctuations, and formally a floating exchange rate system operated, in fact the long term trend of the dollar’s exchange rate was stable.
The worsening US balance of payments situation, already shown in Figure 2, was an inevitable result of the the two circumstances which operated after the mid-1980s. The combination of
a deteriorating competitiveness of the US due to its low investment rate
a stable dollar exchange rate which prevented competitiveness being maintained by devaluation
necessarily meant an increasing movement into deficit of the US balance of payments - precisely as shown in Figure 2. In otherwords the dollar became progressively overvalued compared to the underlying competitiveness of the US economy.
The means whereby this dollar exchange rate remained stable, despite the worsening balance of payments deficit and the fact that the exchange rate was not formally fixed, is shown in Figure 5. Net foreign purchases of US debt instruments, Treasury Bonds and others, rose from around zero per cent of GDP in the early 1980s to 5.6 per cent of GDP in 2007 or $770 billion. The large inflow of investment in US debt instruments counterbalanced the deteriorating current exchange deficit to maintain a stable dollar exchange rate.

Figure 5

It is, however, impossible to cheat underlying economic forces. The history of all economies shows that attempts to artificially maintain a high exchange rate against the pressure of underlying economic forces will eventually fail. In short, at some point, there would inevitably be a dollar devaluation.
The consequences of an overvalued dollar for asset values denominated in dollars are also clear. The values of assets held in overvalued dollars are themselves necessarily overvalued in real international terms. There would, therefore, eventually be a revaluation of such assets downwards to their real, that is lower, values. As that downward revaluation takes place it will erode or destroy the balance sheet of the institutions holding such assets – this is the process which is at present occurring, unleashing the wave of bankruptcy of US financial institutions.
As the dollar devalues, and assets decline towards their real competitive values, two other processes occur.
Foreign holders of dollar assets suffer losses – given that last year alone such inflows, as noted, amounted to $770 billion in US debt instruments any such losses would be large. Japan is estimated to hold $860 billion in US debt instruments, including Treasury Bonds and $75 billion in debt issued previously by the recently nationalised US mortgage institutions Fannie May and Freddie Mac. China is estimated to hold large quantities of US Treasury Bonds and up to $400 billion in Fannie Mae and Freddie Mac debt.
Given the decline in the value of US assets, a political struggle breaks out between different groups in the US population over who will bear the cost of such a fall.
Given the preceeding overvaluation of the dollar it is inevitable that such shifts should take place. In essence the current financial crisis in the US is a classic one of the attempt to maintain an overvalued exchange rate - the type of crisis which affected Mexico in 1982, Russia in 1998, or Argentina in 2001. In each of these cases the inevitable collapse of the attempt to maintain an overvalued currency wrought havoc on the financial institutions of the country concerned. In the case of the US the fact that its economy is on a much larger scale, and plays a pivotal role in the global economy, makes the consequences of such a crisis far more severe.
Why, however, If the crisis is of a rather classical form is there confusion over its driving forces - of the type outlined at the beginning of this article?
The confusion has arisen because a number of commentators in the preceeding period, instead of considering fundamentals and overall trends, took individual facts out of context and created a false ‘narrative’ regarding developments. This perspective was that the US economy was becoming more competitive - to the point where it had created a ‘new economy’. This false perspective was rationalised by looking at a few individual sectors, notably high technology, in which the US is indeed highly competitive. But, as shown in the balance of payments figures, overall the US economy was becoming less, not more, competitive.
The financial crisis is therefore not rooted in psychology nor in short term developments. It is rooted in objective economic processes operating over long periods. The outcome and unfolding of this crisis will, however, be determined by political factors.
The interrelation of these economic and political elements will be looked at in a future post. But the fundamental factors in the situation are clear and flow from the above trends.
If the US were to seek to achieve a level of investment to match its Asian rivals this would, in the short term, due to the huge transfer of resources from consumption to investment that would be required, unleash a wave of popular discontent in the US that would destabilise the political situation - for that reason it is highly unlikely to occur in the short term. The only other way to restore competitiveness in the short term, that is dollar devaluation, would cause radical financial destabilisation as the value of dollar assets declines - destroying the balance sheets of financial institutions holding such assets.Either course will produce strong pressure on the living standards of the US population and therefore have major political impact in the US.

This article was originally published as 'Fundamental driving forces of the financial crisis' on Key Trends in the World Economy

References
[1] For the New York Times: ‘The nation is gripped by the worst financial crisis since the Great Depression.’ For the Wall Street Journal it is ‘Black September' which the papercharacerised simply as 'the worst financial crisis since the 1930s'. The Times characterised the US as suffering from: ‘the cataclysmic fall-out from the country’s worst financial crisis since the Great Depression of the 1930s.’ For the Guardian it was: ‘the most traumatic week on Wall Street since the Great Depression’ For Robert Peston of the BBC: ‘The US Government... admitted that the financial system was on the verge of total meltdown.’
The Wall Street Journal gave a particularly graphic account of the events of 19 September: ‘When government officials surveyed the flailing American financial system this week, they didn't see only a collapsed investment bank or the surrender of a giant insurance firm. They saw the circulatory system of the U.S. economy -- credit markets -- starting to fail.
‘Huddled in his office Wednesday with top advisers, Treasury Secretary Henry Paulson watched his financial-data terminal with alarm as one market after another began go haywire. Investors were fleeing money-market mutual funds, long considered ultra-safe. The market froze for the short-term loans that banks rely on to fund their day-to-day business. Without such mechanisms, the economy would grind to a halt. Companies would be unable to fund their daily operations. Soon, consumers would panic...
‘One day later, Mr. Paulson and Federal Reserve Chairman Ben Bernanke sped to Congress to seek approval for the biggest government intervention in financial markets since the 1930s. In a private meeting with lawmakers, according to a person present, one asked what would happen if the bill failed.
"If it doesn't pass, then heaven help us all," responded Mr. Paulson, according to several people familiar with the matter.’ Similarly: America was “literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally,” Senator Christopher Dodd, Democrat chairman of the Banking, Housing and Urban Affairs Committee reported after the meeting.’
[2] As the Wall Street Journal put it: ‘In Turmoil, Capitalism in U.S. Sets New Course’. More precisely: ‘the biggest financial shock since the Great Depression, is prompting a Republican Treasury secretary and Federal Reserve chairman to devise the most muscular government intervention in the economy since the Great Depression in an effort to prevent the economic devastation of the Great Depression.’
'In March, the Federal Reserve shattered a half-century of tradition in which it had lent money only to banks whose deposits were insured by the government. Declaring circumstances to be "unusual and exigent," as required by a little-used statute, it lent to investment bank Bear Stearns and eventually risked $29 billion of taxpayer money to induce J.P. Morgan Chase to buy Bear. It seemed a very big deal at the time.
‘But in the past two weeks, the U.S. government, keeper of the flame of free markets and private enterprise, has:
‘- nationalized the two engines of the U.S. mortgage industry, Fannie Mae and Freddie Mac, and flooded the mortgage market with taxpayer funds to keep it going;
‘- crafted a deal to seize the nation's largest insurer, American International GroupInc., fired its chief executive and moved to sell it off in pieces.
‘- extended government insurance beyond bank deposits to $3.4 trillion in money-market mutual funds for a year;
‘- banned, for 799 financial stocks, a practice at the heart of stock trading, the short-selling in which investors seek to profit from falling stock prices.
‘- allowed or encouraged the collapse or sale of two of the four remaining, free-standing investment banks, Lehman Brothers and Merrill Lynch;
‘- asked Congress by next week to agree to stick taxpayers with hundreds of billions of dollars of illiquid assets from financial institutions so those institutions can raise capital and resume lending.
‘It was less than a week ago that Mr. Paulson appeared to draw a line at government bailouts, rebuffing Lehman's plea for a Bear Stearns-like rescue and allowing the investment bank to collapse into bankruptcy. "The national commitment to the free market lasted one day," Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, quipped earlier this week. That one day was Monday, Sept. 15. The day before the government rejected Lehman's cry for help; the day after it seized AIG.’
The Financial Times stated the US government: ‘envisage[s] the most extensive peacetime expansion of the role of government in the financial system since the Great Depression and appeared to many to mark the end of an era of Reaganite deregulation.’
[3] The BBC's respected business editor, Robert Peston, for example stated: ‘an entire generation of banking executives had behaved wholly irresponsibly in their lending practices for years’.
[4] Robert Peston, for example, suggesting that what we now have is ‘a stock market that is bereft of reason and is being driven almost purely by hysteria and momentum.’

Why Asia will continue to grow more rapidly than the US and Europe - a historical perspective

Introductory note

Socialist Economic Bulletin is reproducing three articles on the long term background to the current financial crisis which appeared on the blog Key Trends in the World Economy. This blog is published by John Ross, Ken Livingstone's Director of Economic and Business Policy when the latter was Mayor of London. The views expressed in these articles are, however, the personal ones of John Ross and do not necessarily represent the views of Socialist Economic Bulletin.

* * *

Data on long term trends in investment and economic growth

This post deals with the historic trend of investment and economic growth. This may appear a relatively esoteric topic. In fact, however, it has decisive economic and strategic business consequences - in particular for understanding the more rapid growth of the key Asian economies relative to the US and Europe and why this will continue for a prolonged period. Before dealing with these and other more detailed implications, however, the factual data is set out.
Figure 1 shows the percentage of fixed investment (gross fixed capital formation) in GDP for a series of major countries over the longest periods of time for which data is available. [1]

Figure 1

The pattern is clear and striking. By far the strongest trend is for the proportion of GDP devoted to fixed investment (gross domestic fixed capital formation) to rise with time. This in turn, as will be shown, is associated with progressively rising rates of economic growth.
Considering countries in the chronological order in which a new peak in the proportion of GDP devoted to gross fixed domestic capital formation appeared the following is the historical pattern.
- Commencing with the period immediately antedating the industrial revolution, the proportion of GDP devoted to fixed investment in England and Wales, at the end of the 17th century, was 5-7 per cent. [2] This rose slightly, although current estimates are that it did not rise greatly, during the 19th century - peaking at over ten percent of UK GDP prior to World War I.
This level of investment was sufficient to launch the first industrialisation of any country but at a rate of growth which, while unprecedented at the time, was extremely slow by contemporary international standards - about two per cent a year. With such a growth rate it takes 35 years for an economy to double in size and 70 years to quadruple.
- Turning to the latter part of the 19th century, the proportion of US GDP devoted to fixed investment had risen to considerably exceed that for the UK – reaching a level of 18-20 per cent of GDP by the last decades of the century.
A sharp fall in the proportion of the US economy devoted to fixed investment commenced in the late 19th century, and was particularly pronounced during the period between World War I and World War II – being associated with the great depression of the inter-war period. After World War II the US resumed its pattern of 18-20 per cent of GDP being devoted to gross fixed capital formation. This generated an average growth rate of 3.5 per cent a year. With such a growth rate an economy doubles in size every 20 years and quadruples in size every 40 years. It was on the basis of this historical level of investment, and growth rate, that the US overtook Britain to become the world’s greatest economic power.
- In the period following World War II Germany achieved a level of fixed investment exceeding 25 per cent of GDP – peaking at 26.6 per cent in 1964. This period 1951-64 was that of the post-war German ‘economic miracle’ with average growth of 6.8 per cent a year - with such a growth rate an economy doubles in size every 11 years and quadruples in 22 years.
- Starting at the beginning of the 1960s Japan achieved a level of gross domestic fixed capital formation of more than 30 per cent of GDP. This reached a peak in the early 1970s, at 35 per cent of GDP, before later sharply falling. During that period the average annual rate of growth of the Japanese economy was 8.6 per cent. With such a growth rate an economy doubles in size in eight and half years and quadruples in size in 17 years.
- From the 1970s onwards, South Korea similarly achieved a level of fixed investment of 30 per cent of GDP. During the 1980s this rose above 35 per cent of GDP. The other East Asian ‘Tiger’ economies – Singapore, Hong Kong and Taiwan – showed a similar pattern. South Korea’s economy confirmed the relation between fixed investment and economic growth illustrated by Japan by growing in this period by an average 8.3 per cent a year. At such a growth rate an economy doubles in size in nine years and quadruples in 18.
Such growth rates in Asia showed that something unprecedented in human history was now possible – that it was possible to industrialise an economy, and achieve a ‘first world’ level of development, in a single generation.
- From the early 1990s onwards China achieved sustained rates of fixed investment of 35 per cent of GDP with, from the beginning of the 21st century, this rising to more than 40 per cent of GDP – a level never before winessed in human history. The result was average 9.8 per cent a year economic growth over a sustained period – also the most rapid sustained economic growth ever seen in human history. On that basis an economy doubles in size every seven and a half years and quadruples in size in 15 years.
- To complete the chronological picture, the proportion of GDP devoted to fixed investment for two countries recently undergoing rapid economic growth, India and Vietnam, is shown. The proportion of Indian GDP devoted to fixed investment has not reached the Chinese level but has become high – reaching 34 per cent of GDP in 2007. On this basis, in the last five years, India has achieved an average growth rate of 8.8 per cent a year. At that rate of growth India’s economy doubles in size in slightly over eight years and quadruples in sixteen and a half years.
In Vietnam the proportion of GDP devoted to fixed investment rose from 13 per cent in 1990 to 25 per cent in 1995 to 37 per cent in 2007. Economic growth has accelerated rapidly, rising to an average of 7.9 per cent a year in the five years up to 2007. At that rate of growth Vietnam’s economy doubles in slightly under 9 years and quadruples in size in 18 years.
Considering these trends, such a high level of investment is a necessary condition for rapid economic growth. No substantial country without comparable high levels of fixed investment has achieved such rapid rates of growth on a sustained basis. [3] But it is not a sufficient condition: the high level of investment is also linked to the scale of production, that is the size of the market being produced for. In a modern economy only large scale production can be efficient in the decisive sectors of production, requiring an orientation to the international market – this is particularly evident with such high levels of investment.
No purely national market, not even the US or China, is sufficiently large to maintain the most efficient level of production. As many others have frequently correctly stressed, high levels of investment must therefore be accompanied by an export orientation. [4] It is this high level of investment, accompanied by an export orientation, which was responsible for the rapid economic growth of South Korea, China, India and Vietnam.

Implications of different investment levels

There are a number of clear consequences of these factual trends (it must be stressed that this data, of course, deals only with long and medium term trends and is not a guide to short term fluctuations). Among the most important of these implictions are:
- It provides a clear historical framework for understanding the present rapid growth of (primarily Asian) economies and why they will continue to grow far more rapidly than the US and Europe.
- China’s economy will continue to outperform India’s and the gap between the two will grow - and not shrink as some have suggested.
- There is no serious historical evidence for the thesis sometimes presented that China is oversaving/overinvesting. China therefore should seek to maintain, and not cut, its current savings and investment levels.
- Current US/UK economic policy, with its overwhelming emphasis on microeconomic efficiency of resource allocation, fails to address the most important economic issues and therefore will be unsuccessful – which will deepen the tendency for the key Asian economies to grow more rapidly than the US and Europe. The also provides a background to current issues in the credit crunch.
Taking these issues in more detail:
First, these trends place in wider historical context the present rapid growth of a number of (primarily Asian) economies. The latter represent the latest high point in the trend for higher and higher proportions of GDP to be devoted to fixed investment. Consideration of such trends therefore provides a clear theoretical underpinning for the evident current empirical fact that not only is Asia growing substantially more rapidly than the US and Europe but that it will continue to do so. The investment rates in the key Asian economies are not aberrantly high but merely the latest point in an historical trend.
Seen in long term historical perspective it is US and European savings and investment rates that are too low, not Asian savings and investment rates that are too high.
Second, given these historic trends, it is clear that on the basis of current macroeconomic trends China’s economy will continue to expand more rapidly than India's and that China will increase its economic lead over the latter.
This naturally does not mean anything other than that India is an extraordinarily important market. India’s economy is, at a realistic exchange rate, in Parity Purchasing Power (PPP) terms, the fourth largest economy in the world after the US, China and Japan.[6] India's economic growth, running at around at 8-9 per cent a year, is the second largest for any major economy in the world after China. However, China’s economy is already approximately two and a half times the size of India’s in PPP terms and is continuing to grow at one to two per cent a year more rapidly than India – this combination ensuring that the gap between China and India is widening and not narrowing. There is also no evidence from consideration of historical data that the factors invoked to claim that India’s economy will grow more rapidly than China’s, for example different demographic profiles, are crucial. The historical evidence is that it is the proportion of the economy devoted to gross fixed capital formation that is decisive. The fact that, until the present, the Chinese economy continues to devote a significantly higher proportion of the economy to fixed investment than India – 43 per cent compared to 34 per cent to take the latest available years, indicates that unless India catches up with China in terms of this area China will grow more rapidly than India.
Third, there is no evidence from this historical trend data for the argument that China is facing a basic crisis of oversaving/overinvestment, and therefore that China needs to lower its total savings level (i.e. savings including private, public and corporate saving) and to increase consumption - as some commentators, including the Financial Times chief economics commentator Martin Wolf, have stated. [5]
It is evident that China’s level of investment and saving is far higher than that of the US or UK. However the historical data make clear that China’s is simply the latest stage in the long term trend for an increasing proportion of GDP to be devoted to gross fixed capital formation. Given this rising historical trend it is entirely likely that in the future another country, or China itself, will have a higher proportion of GDP devoted to saving/investment than China today - yielding a higher rate of growth.
While, of course, short term fluctuations and adjustments may be required there is no historical evidence that China's savings and investment rate is excessively high - it is merely the latest stage in a long term international historical trend. Reduction of China’s investment and savings rate would lead to slowdown not only of China’s economy but also, because of its locomotive role in the world economy, a slowdown in the global economy. China should therefore be seeking to maintain, not reduce, its current high investment and savings levels.
Fourth, there is no evidence from the historical data that the 'quality of entrepreneurship' plays any crucial role in economic development. Or more precisely, and what is another way of saying the same thing, the quality of entrepreneurship and managerial effectiveness appears to be randomly distributed and therefore cannot explain differences in economic growth rates. There are no cases where, due to the 'quality of entrepreneurship', countries have experienced rapid growth without high levels of gross domestic fixed capital formation in GDP.
Fifth, present US/UK government economic policy, by according overwhelming centrality to dealing with microeconomic efficiency, is addressing relatively minor issues in terms of international competitiveness compared to that of dealing with inadequate saving and investment rates. The economic priorities of a number of rapidly growing Asian economies will therefore clearly be more effective than that of the US and UK.
Put in other terms, the implications for governments’ economic policies of the long term trends outlined here is that in a balance between seeking microeconomic efficiency in the allocation of resources, and seeking a high level of savings and investment, the high level of savings and investment is more important that the emphasis on microeconomic efficiency from the point of view of creating economic growth.
There is an entirely reasonable supposition that the microeconomic allocation of investment in South Korea or China, given the use of subsidised loans, cross forms of ownership in different branches of industry, higher capital/output ratios etc, is less microeconomically efficient than in the UK or the US. However the rate of growth of the South Korean or Chinese economies is much more rapid, over a sustained period, than that of the UK or US.
Quantitatively the greater microeconomic efficiencies in allocation of resources in the US or UK, to generate an equal rate of growth, would have to compensate for their lower savings and investment ratios and there is no evidence that it does so. It is the higher savings and investment rates in Asian economies that predominate over greater microeconomic efficiency. Therefore any quality of microeconomic priorities in the US and UK will be overwhelmed by the quantity of investment in the rapidly growing economies of Asia.
Ideally, of course, both high microeconomic efficiency and high savings/investment levels should be sought. However there is evidence that the two are contradictory. For example the policies pursued in the US and UK have been accompanied by massive declines of savings rates which have undermined the competitiveness of the economy – leading into present sharp financial problems. It is therefore likely that current US and UK economic policy will be unsuccessful, and these economies will remain under financial pressure created by lack of competitiveness for a prolonged period. The credit crunch is a one periodic form of the manifestation of this loss of competitiveness by the US and UK.

Conclusions

The following clear conclusion may be drawn from this data:
There is a clear historical trend for the proportion of the economy devoted to gross domestic fixed capital formation to rise. This is the key determinant of rising rates of economic growth.
Five key historic stages in the rise in this proportion of the economy devoted to fixed investment may be identified: the achievement of a 5-7 per cent investment rate in Britain in the 18th century permitting the launching of the industrial revolution; an 18-20 per cent of GDP fixed investment rate from the latter part of the 19th century, achieved by a number of countries led by the US, which permitted the United States to replace the UK as the world's leading economic power; a 25 per cent of GDP fixed investment rate in Germany in the immediate post-World War II period which accompanied the German 'economic miracle'; a more than 30 per cent of GDP rate of fixed investment achieved in Japan, and then the other East Asian 'Tiger' economies, from the mid-1960s which permitted growth rates of more than 8 per cent a year; a more than 35 per cent of GDP fixed investment rate in China from the 1990s onwards which has permitted sustained growth rates approaching 10 per cent a year.
On the basis of this differential in investment rates a number of the key Asian economies will continue to outperform the US and Europe in terms of economic growth for a prolonged period.
China will continue to increase its economic lead over India - although the latter will experience rapid economic growth.
There is no historical evidence China is oversaving or overinvesting and it should seek to strategically maintain, and not cut, its present investment and saving rates.
Current US and UK economic policy addresses secondary issues and therefore is unlikely to be successful.

This article originally appeared as 'Why Asia will continue to grow more rapidly than the US and Europe - a historical perspective' on Key Trends in the World Economy

References

[1] The figure for England for 1688 is that in Angus Maddison, The World Economy, OECD Paris 2006 p395. UK figures after 1688 and up to 1947 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p74. Figures from 1948 are calculated from International Monetary Fund, International Financial Statistics (August 2008) Minor adjustments have been made to chain the earlier statistics to be consistent with the IMF data – in no case does this make any significant difference to the pattern shown. The data for fixed investment for the earlier period used by The Economist One Hundred Years of Economic Statistics are based on calculations in C H Feinstein and Pollard Studies in Capital Formation in the United Kingdon 1750-1820, Oxford University Press, Oxford 1988. Other commentators have suggested that Feinstein and Pollard's figures are somewhat too high - see for example. N F R Crafts British Economic Growth during the Industrial Revolution, Clarendon, Oxford 1986 p73. None of these revisions and differences however is of sufficient magnitude to alter the fundamental pattern shown here.
US figures prior to 1948 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p74. Figures from 1948 are calculated from International Monetary Fund, International Financial Statistics (August 2008) Data for the earlier period give only private fixed capital formation whereas that after 1948 is for total fixed capital formation – i.e. including government fixed capital formation. There are no reliable estimates of government fixed capital formation in the earlier period and therefore data for the earlier period have been adjusted upward by the difference between the two in 1948 – which is slightly over two per cent of GDP. This has the effect of revising upwards slightly the percentage of GDP allocated to fixed investment in the earlier period but the difference is too small to affect the overall pattern.
Figures for Germany prior to 1960 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p202. Figures from 1960 are calculated from International Monetary Fund, International Financial Statistics (August 2008). There is however no significant statistical difference between the two.
Figures for Japan, South Korea, China, India and Vietnam calculated from International Monetary Fund, International Financial Statistics.

[2] Phyllis Deane and W A Cole in British Economic Growth 1688-1959, Cambridge University Press, Cambridge 1980 p2 being closer to the lower figure while further studies have tended to revise the figure upwards slightly. The higher estimates for the earlier period have been taken here so as to avoid any suggestion of exaggerating the degree to which the proportion of GDP devoted to Gross Domestic Fixed Capital Formation has risen. The precise figure used here is that calculated by Maddison in Angus Maddison, The World Economy, OECD Paris 2006 p395. The higher figure, as can be seen, makes no difference to the overall trend.

[3] The only exceptions are the extremely small states, with populations of less than two million, of Equatorial Guinea and Botswana - which are so small their economic conditions can be essentially wholly determined by external factors.

[4] A particularly coherent theoretical explanation of this may be found in N Lardy Foreign Trade and Economic Reform in China, Cambridge University Press, Cambridge 1993.

[5] See for example Beijing should dip into China’s corporate bank and China should risk bolder trials. Similar views are expressed in The Growth Report: Strategies For Sustained Growth And Inclusive Development

[6] For a convenient survey of the latest calculations in this field see http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP.