What, if Anything, Will Sink the Global Economy?Published: December 15, 2004 in Knowledge@Wharton
While the global economy has been growing at a healthy pace, the prospect of rising interest rates, a housing market crash, oil price shocks and instability in the Chinese economy could create setbacks in the future, according to speakers on a recent Wharton Finance Conference panel titled, "The Global Economy: Have Traction, Will Travel."
"Overall, the global economy today is strong," stated Frederic Neumann, adjunct professor in Southeast Asia Studies at The Johns Hopkins University School of Advanced International Studies. Worldwide economic growth is predicted to be 5% this year and 4.3% next year, he said, while in Asia, Japan is showing signs of revival and China is growing fast, perhaps too fast. Europe, too, is growing at a respectable rate with some countries in Eastern Europe, such as Poland and the Czech Republic, outstripping the rest of the continent. International trade is growing at a rate of 8% to 9% a year, well above historic averages.
Global Real Estate Bubble
Going forward, he said, there are risks. He pointed to the rise in the cost of oil, which has not been fully priced into financial markets, and stressed the likelihood of rising interest rates and the possibility of inflation spurred by loose monetary policy in the United States and many other countries, including China. Housing markets, which have boomed in the United States and around the world, are vulnerable, with a "real estate bubble going on practically across the entire globe," said Neumann. "Higher interest rates will cause problems in [that sector]."
Financial investments will not be hurt too much, he predicted. Western banks and Japanese banks are in relatively good health, although emerging markets will be damaged by higher borrowing costs. Finally, large U.S. economic imbalances are another potential problem for the world's economy. The U.S. current account deficit has ballooned to the point where the International Monetary Fund would probably have stepped in if similar imbalances were present in a less-influential nation. "There is inherent risk. Ultimately, symptomatically, it reflects very little savings in the U.S. We need to reduce consumption - either public consumption or private consumption - and increase savings."
The risks, Neumann added, are challenges for policymakers, not fundamental economic forces. "If we don't address those, I think this recovery will be relatively short-lived."
An Overheated China
Victoria Marklew, vice president and senior international economist at Northern Trust in Chicago, also raised concerns about both the U.S. current account deficit and the Chinese economy. She pointed out that low long-term interest rates in the United States are a reflection of foreign central bank purchases of dollar-denominated instruments to maintain the stability of their own currencies. Low rates in the United States have helped to put household debt, relative to GDP, at post-World War II records. "Sooner or later, U.S. consumers will have to start to save more."
Meanwhile, in China there is excess liquidity, and because government does most credit allocation, the result is a chronic misdirection of capital, said Marklew. "The outcome of all this is we have a booming economy in the U.S. and China. Here in the U.S., we have excessive levels of consumption, in China excessive levels of liquidity.
"Does the global economy have traction?" she asked. "No." The Chinese economy is overheating and may not be able to hold its currency stable against the dollar much longer. If China can slow its economic growth gradually from 11% to 7%, it would be "a minor miracle." An abrupt slowdown would shock global financial markets.
"It is not in the Chinese authorities' interest to maintain cheap loans very much longer. It is not part of their long-term strategy. You cannot control exchange rates and inflation indefinitely," she said. The Chinese "are having problems with consumer price inflation and asset price inflation. All the liquidity is an enormous policy problem. Sometime in the next 12 to 18 months, there will be an adjustment in their currency peg."
Marklew pointed to several risks to the global economy that could surface in 2005. "We are starting to see an end to easy global money. There is a risk of a global slowdown in 2005 and possibly the risk of a global housing market slump." Marklew, too, said the United States is not the only nation with a housing-price bubble. "As interest rates rise, there is a significant risk of a housing market collapse." A decline in housing prices, she said, takes a greater toll on an economy than a decline in other asset prices. "Economists are worried because a housing market slump hits consumers hard - much more than a stock-market correction."
Finally, oil prices are another risk in 2005, noted Marklew, adding that it is difficult to factor future oil prices into forecasts. Japan is particularly vulnerable to an increase in oil prices at this stage of its tentative recovery, even though it has made strides to reduce oil use. "Rising local oil prices will take a bite out of Japanese corporate profits just as profits are starting up again," said Marklew, citing research indicating that a rise in oil prices has a strong impact on GDP seven quarters after the price hike.
"Sucking in Imports"
Stephen A. Meyer, vice president and senior economic policy advisor at the Federal Reserve Bank of Philadelphia, was more upbeat over the long-term. "When I think about long-term growth, I think about supply-side factors: growth in capital, growth in technology, and growth in labor and skills. Long-term growth comes from more tools, more workers, better workers," he said. "What you are hearing about are the short-run oscillations that reflect the demand side - consumer demand, business demand for investment, exports and so on."
According to Meyer, consensus forecasts indicate the U.S. economy will grow by 4% this year and a little less in 2005, driven by continued moderate growth in consumer spending and "fairly robust business spending." It is probably not enough growth, however, to get unemployment below 5% by the end of the year, he said.
He pointed out that forecasters believe any increase in interest rates will be gradual. "What the Fed is aiming for is a path for interest rates that grows at full employment," said Meyer, who began his remarks saying he was presenting his own opinions, not official Fed policy.
Looking globally, he predicted the economies of Canada and Mexico will benefit as the United States continues to "suck in imports." In Europe, interest rates are rising to slow inflation. As for China, its economy is beginning to slow, but not as a result of government actions. "The people who have been building are recognizing they are getting a little ahead." The pullback may wind up being abrupt and painful, with runs on domestic banks.
Oil will also have an impact on industrializing Asian economies, depending on whether they import or export oil, Meyer noted. "I suggest the big risk in oil is not $50 a barrel, not even if it continues to rise gradually. The big negative would be a significant reduction of supply. Could that happen? Yes. The odds strike me as low, but the risk is there."
Meyer stressed that demographics will play a large part in shaping the global economy long-term. In India, the sex ratio has been skewed to the point where there are significantly more men than women. In China, authorities are beginning to grow concerned that the one-child policy will result in a dearth of workers to support its older population.
The same issue is looming in the United States, he said. "The concern is not that the Social Security system is in trouble, but that we are going to have a lot of people who want to retire and continue consuming. The problem is, where will we get the workers and the capital to make the goods and services that older people want?"
George Melloan, deputy international editor of The Wall Street Journal, said he is optimistic about the global economy and the "incredible changes in poor countries of the world like China and India." He is not overly concerned about the U.S. deficit with the rest of the world. "The U.S. has had a current account deficit for a long time and it's very large now. As a result, countries that hold U.S. debt have developed a very strong interest in that debt maintaining its value. What we have worried about all these years hasn't happened yet and it doesn't look like we're in any real danger of it happening."