Low growth – the new economic reality

Stephen King

March 3, 2014

Until recently, the US was always the world’s consumer of last resort”. Since the collapse of the Bretton Woods exchange rate system in the early-1970s and the subsequent huge increase in cross-border capital flows, the US easily absorbed more and more of the world’s surplus savings. This was particularly so in recoveries after US recessions. The US current account moved into modest deficit in the late-1970s and into much larger deficit in the 1980s. Thereafter, the deficits got even bigger, reaching a peak of almost 6 per cent of US gross domestic product before the onset of the global financial crisis.

The latest US recovery is, thus, unique. This time, the current account deficit has continued to shrink. Lots of explanations are offered, most obviously the decline in America’s dependency on imported fossil fuels thanks to the shale energy revolution. Yet, if that were true, Saudi Arabia and other oil producers should be running much smaller current account surpluses; mostly, they are not.

A more plausible explanation lies instead with the nature of the US’s own economic recovery. It has been decidedly anaemic. In a dismal shift from the US experience in earlier economic cycles, domestic demand has risen at an average annual rate since the 2007 peak of only 0.6 per cent. That compares with average annual gains of more than 3 per cent during equivalent time periods from the 1970s onwards. The gains from the 2009 trough have been similarly insipid.

Domestic demand weakness reflects a whole host of factors: last year’s sequestration courtesy of Washington; supply-side disappointment associated with abnormally low productivity growth; corporate conservatism; incredibly weak growth of real personal disposable income; and monetary stimulus that may have boosted the coffers of the low-spending wealthy but was not so helpful for the remaining 99 per cent of the income distribution.

Whatever the causes, however, it is clear that the US is not performing its traditional role as consumer of last resort. This has profound global implications. If the US current account deficit is not widening out in the usual way, it must follow that other countries are experiencing either smaller surpluses or bigger deficits. Put another way, the excess savings that used to flow into the US have gone elsewhere.

At first sight this might seem a good thing. After all, the widening of the US current account deficit in the years running up to the financial crisis was ultimately a reflection of excess inflows that drove down bond yields, encouraged a huge credit expansion, contributed to an unsustainable housing boom and, eventually, a partial meltdown of the global financial system. If excess savings are now going elsewhere, perhaps we should be cheering.

That assumes, however, that returns elsewhere are halfway decent. The evidence increasingly suggests they have not been. One offset to America’s smaller current account deficit has been a much smaller Chinese current account surplus reflecting Beijing’s attempt to boost domestic investment in response to flagging exports. Yet recent developments suggest that the marginal return on Chinese investment has plunged

Another offset has been the rapid widening of current account deficits in parts of the emerging world; again, there is scant evidence to suggest that the associated capital inflows did anything other than create an unsustainable credit boom. Now the UK finds itself in a similar position. Its current account deficit rose to more than 5 per cent of GDP in the third quarter of 2013 in only the first year of a recovery that is too heavily skewed towards housing and leverage.

Excess savings went elsewhere because the US no longer seemed to offer decent returns, a view reinforced by a Federal Reserve determined to keep monetary conditions as loose as possible. Those savings, in turn, pushed returns lower elsewhere leading in some cases to economic disappointment and financial upheaval.

We have a global savings glut but, unlike the early years of the century, those savings have no place to go. Unless the US is able to reprise its role as consumer of last resort or other nations are able to pick up the baton, we may now be facing a world of persistently low growth and much lower returns which, given weak productivity gains, may, unfortunately, be our new economic reality. That combination, in turn, might explain why, despite the best efforts of central banks, inflation in the developed world is mostly too low, not too high.

The writer is chief global economist for HSBC Bank

Malthus, Marx, and Modern Growth

Kenneth Rogoff

MAR 4, 2014

CAMBRIDGEThe promise that each generation will be better off than the last is a fundamental tenet of modern society. By and large, most advanced economies have fulfilled this promise, with living standards rising over recent generations, despite setbacks from wars and financial crises.

In the developing world, too, the vast majority of people have started to experience sustained improvement in living standards and are rapidly developing similar growth expectations. But will future generations, particularly in advanced economies, realize such expectations? Though the likely answer is yes, the downside risks seem higher than they did a few decades ago.

So far, every prediction in the modern era that mankind’s lot will worsen, from Thomas Malthus to Karl Marx, has turned out to be spectacularly wrong. Technological progress has trumped obstacles to economic growth. Periodic political rebalancing, sometimes peaceful, sometimes not, has ensured that the vast majority of people have benefited, albeit some far more than others.

As a result, Malthus’s concerns about mass starvation have failed to materialize in any peaceful capitalist economy. And, despite a disconcerting fall in labor’s share of income in recent decades, the long-run picture still defies Marx’s prediction that capitalism would prove immiserating for workers. Living standards around the world continue to rise.

But past growth performance is no guarantee that a broadly similar trajectory can be maintained throughout this century. Leaving aside potential geopolitical disruptions, there are some formidable challenges to overcome, mostly stemming from political underperformance and dysfunction.

The first set of issues includes slow-burn problems involving externalities, the leading example being environmental degradation. When property rights are ill-defined, as in the case of air and water, government must step in to provide appropriate regulation. I do not envy future generations for having to address the possible ramifications of global warming and fresh-water depletion.

A second set of problems concerns the need to ensure that the economic system is perceived as fundamentally fair, which is the key to its political sustainability. This perception can no longer be taken for granted, as the interaction of technology and globalization has exacerbated income and wealth inequality within countries, even as cross-country gaps have narrowed.

Until now, our societies have proved remarkably adept at adjusting to disruptive technologies; but the pace of change in recent decades has caused tremendous strains, reflected in huge income disparities within countries, with near-record gaps between the wealthiest and the rest. Inequality can corrupt and paralyze a country’s political system – and economic growth along with it.

The third problem is that of aging populations, an issue that would pose tough challenges even for the best-designed political system. How will resources be allocated to care for the elderly, especially in slow-growing economies where existing public pension schemes and old-age health plans are patently unsustainable? Soaring public debts surely exacerbate the problem, because future generations are being asked both to service our debt and to pay for our retirements.

The final challenge concerns a wide array of issues that require regulation of rapidly evolving technologies by governments that do not necessarily have the competence or resources to do so effectively. We have already seen where poor regulation of rapidly evolving financial markets can lead. There are parallel shortcomings in many other markets.

A leading example is food supply – an area where technology has continually produced ever-more highly processed and genetically refined food that scientists are only beginning to assess. What is known so far is that childhood obesity has become an epidemic in many countries, with an alarming rise in rates of type 2 diabetes and coronary disease implying a significant negative impact on life expectancy in future generations.

Many leading health researchers, including Kelly Brownell, David Ludwig, and Walter Willett, have documented these problems. Government interventions to date, mainly in the form of enhanced education, have proved largely ineffective. Self-destructive addiction to processed foods, which economists would describe as an “internality,” can lower quality of life for those afflicted, and can eventually lead to externalities for society, such as higher health-care costs. Again, despite a rising chorus of concern from researchers, political markets have seemed frozen.

All of these problems have solutions, at least in the short to medium run. A global carbon tax would mitigate climate risks while alleviating government debt burdens. Addressing inequality requires greater redistribution through national tax systems, together with enhanced programs for adult education, presumably making heavy use of new technologies. The negative effects of falling population growth can be mitigated by easing restrictions on international migration, and by encouraging more women and retirees to enter or stay in the workforce. But how long it will take for governments to act is a wide-open question.

Capitalist economies have been spectacularly efficient at enabling growing consumption of private goods, at least over the long run. When it comes to public goodssuch as education, the environment, health care, and equal opportunity – the record is not quite as impressive, and the political obstacles to improvement have seemed to grow as capitalist economies have matured.

Will each future generation continue to enjoy a better quality of life than its immediate predecessor? In developing countries that have not yet reached the technological frontier, the answer is almost certainly yes. In advanced economies, though the answer should still be yes, the challenges are becoming formidable.

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. His most recent book, co-authored with Carmen M. Reinhart, is This Time is Different: Eight Centuries of Financial Folly.

Ukraine and the 'Little Cold War'

Tuesday, March 4, 2014 - 03:09 


Editor's Note: In place of George Friedman's regular Geopolitical Weekly, this column is derived from two chapters of Friedman's 2009 book, The Next 100 Years. We are running this abstract of the chapters that focused on Eastern Europe and Russia because the forecast -- written in 2008 -- is prescient in its anticipation of events unfolding today in Russia, Ukraine and Crimea.

By George Friedman

We must consider the future of Eurasia after the fall of the Soviet Union. Since 1991, the region has fragmented and decayed. The successor state to the Soviet Union, Russia, is emerging from this period with renewed self-confidence. Yet Russia is also in an untenable geopolitical position. Unless Russia exerts itself to create a sphere of influence, the Russian Federation could itself fragment.

For most of the second half of the 20th century, the Soviet Union controlled Eurasia -- from central Germany to the Pacific, as far south as the Caucasus and the Hindu Kush. When the Soviet Union collapsed, its western frontier moved east nearly 1,000 miles, from the West German border to the Russian border with Belarus. Russian power has now retreated farther east than it has been in centuries. During the Cold War it had moved farther west than ever before. In the coming decades, Russian power will settle somewhere between those two lines.

After the Soviet Union dissolved at the end of the 20th century, foreign powers moved in to take advantage of Russia's economy, creating an era of chaos and poverty. Most significantly, Ukraine moved into an alignment with the United States and away from Russia -- this was a breaking point in Russian history.

The Orange Revolution in Ukraine, from December 2004 to January 2005, was the moment when the post-Cold War world genuinely ended for Russia. The Russians saw the events in Ukraine as an attempt by the United States to draw Ukraine into NATO and thereby set the stage for Russian disintegration. Quite frankly, there was some truth to the Russian perception.

If the West had succeeded in dominating Ukraine, Russia would have become indefensible. The southern border with Belarus, as well as the southwestern frontier of Russia, would have been wide open.

Russia's Resurgence

After what Russia regarded as an American attempt to further damage it, Moscow reverted to a strategy of reasserting its sphere of influence in the areas of the former Soviet Union. The great retreat of Russian power ended in Ukraine. For the next generation, until roughly 2020, Russia's primary concern will be reconstructing the Russian state and reasserting Russian power in the region.

Interestingly, the geopolitical shift is aligning with an economic shift. Vladimir Putin sees Russia less as an industrial power than as an exporter of raw materials, the most important of which is energy (particularly natural gas). He is transforming Russia from an impoverished disaster into a poor but more productive country. Putin also is giving Russia the tool with which to intimidate Europe: the valve on a natural gas pipeline.

But the real flash point, in all likelihood, will be on Russia's western frontier. Belarus will align itself with Russia. Of all the countries in the former Soviet Union, Belarus has had the fewest economic and political reforms and has been the most interested in recreating some successor to the Soviet Union. Linked in some way to Russia, Belarus will bring Russian power back to the borders of the former Soviet Union.

From the Baltics south to the Romanian border there is a region where borders have historically been uncertain and conflict frequent. In the north, there is a long, narrow plain, stretching from the Pyrenees to St. Petersburg. This is where Europe's greatest wars were fought. This is the path that Napoleon and Hitler took to invade Russia. There are few natural barriers. Therefore, the Russians must push their border west as far as possible to create a buffer. After World War II, they drove into the center of Germany on this plain

Today, they have retreated to the east. They have to return, and move as far west as possible. That means the Baltic states and Poland are, as before, problems Russia has to solve.

Defining the limits of Russian influence will be controversial. The United States -- and the countries within the old Soviet sphere -- will not want Russia to go too far.

Russia will not become a global power in the next decade, but it has no choice but to become a major regional power. And that means it will clash with Europe. The Russian-European frontier remains a fault line.

It is unreasonable to talk of Europe as if it were one entity. It is not, in spite of the existence of the European Union. Europe consists of a series of sovereign and contentious nation-states.

In short, post-Cold War Europe is in benign chaos. Russia is the immediate strategic threat to Europe. Russia is interested not in conquering Europe, but in reasserting its control over the former Soviet Union. From the Russian point of view, this is both a reasonable attempt to establish some minimal sphere of influence and essentially a defensive measure.

Obviously the Eastern Europeans want to prevent a Russian resurgence. The real question is what the rest of Europe might do -- and especially, what Germany might do. The Germans are now in a comfortable position with a buffer between them and the Russians, free to focus on their internal economic and social problems. In addition, the heritage of World War II weighs heavily on the Germans. They will not want to act alone, but as part of a unified Europe.

Russia is the eastern portion of Europe and has clashed with the rest of Europe on multiple occasions. Historically, though, Europeans who have invaded Russia have come to a disastrous end. If they are not beaten by the Russians, they are so exhausted from fighting them that someone else defeats them. Russia occasionally pushes its power westward, threatening Europe with the Russian masses. At other times passive and ignored, Russia is often taken advantage of. But, in due course, others pay for underestimating it.

Geographic Handicaps, Energy Assets

If we are going to understand Russia's behavior and intentions, we have to begin with Russia's fundamental weakness -- its borders, particularly in the northwest. On the North European Plain, no matter where Russia's borders are drawn, it is open to attack. There are few significant natural barriers anywhere on this plain. Pushing its western border all the way into Germany, as it did in 1945, still leaves Russia's frontiers without a physical anchor. The only physical advantage Russia can have is depth. The farther west into Europe its borders extend, the farther conquerors have to travel to reach Moscow. Therefore, Russia is always pressing westward on the North European Plain and Europe is always pressing eastward.

Europe is hungry for energy. Russia, constructing pipelines to feed natural gas to Europe, takes care of Europe's energy needs and its own economic problems, and puts Europe in a position of dependency on Russia. In an energy-hungry world, Russia's energy exports are like heroin. It addicts countries once they start using it. Russia has already used its natural gas resources to force neighboring countries to bend to its will. That power reaches into the heart of Europe, where the Germans and the former Soviet satellites of Eastern Europe all depend on Russian natural gas. Add to this its other resources, and Russia can apply significant pressure on Europe.

Dependency can be a double-edged sword. A militarily weak Russia cannot pressure its neighbors, because its neighbors might decide to make a grab for its wealth. So Russia must recover its military strength. Rich and weak is a bad position for nations to be in. If Russia is to be rich in natural resources and export them to Europe, it must be in a position to protect what it has and to shape the international environment in which it lives.

In the next decade, Russia will become increasingly wealthy (relative to its past, at least) but geographically insecure. It will therefore use some of its wealth to create a military force appropriate to protect its interests, buffer zones to protect it from the rest of the world -- and then buffer zones for the buffer zones. Russia's grand strategy involves the creation of deep buffers along the North European Plain, while it divides and manipulates its neighbors, creating a new regional balance of power in Europe. What Russia cannot tolerate are tight borders without buffer zones, and its neighbors united against it. This is why Russia's future actions will appear to be aggressive but will actually be defensive.

Russia's actions will unfold in three phases. In the first phase, Russia will be concerned with recovering influence and effective control in the former Soviet Union, re-creating the system of buffers that the Soviet Union provided it. In the second phase, Russia will seek to create a second tier of buffers beyond the boundaries of the former Soviet Union. It will try to do this without creating a solid wall of opposition, of the kind that choked it during the Cold War. In the third phase -- really something that will have been going on from the beginning -- Russia will try to prevent anti-Russian coalitions from forming.

If we think of the Soviet Union as a natural grouping of geographically isolated and economically handicapped countries, we can see what held it together. The countries that made up the Soviet Union were bound together of necessity. The former Soviet Union consisted of members who really had nowhere else to go. 

These old economic ties still dominate the region, except that Russia's new model, exporting energy, has made these countries even more dependent than they were previously. Attracted as Ukraine was to the rest of Europe, it could not compete or participate with Europe. Its natural economic relationship is with Russia; it relies on Russia for energy, and ultimately it tends to be militarily dominated by Russia as well.

These are the dynamics that Russia will take advantage of in order to reassert its sphere of influence. It will not necessarily recreate a formal political structure run from Moscow -- although that is not inconceivable. Far more important will be Russian influence in the region over the next five to 10 years.

The Russians will pull the Ukrainians into their alliance with Belarus and will have Russian forces all along the Polish border, and as far south as the Black Sea. This, I believe, will all take place by the mid-2010s.

There has been a great deal of talk in recent years about the weakness of the Russian army, talk that in the decade after the collapse of the Soviet Union was accurate. But here is the new reality -- that weakness started to reverse itself in 2000, and by 2015 it will be a thing of the past. The coming confrontation in northeastern Europe will not take place suddenly, but will be an extended confrontation. Russian military strength will have time to develop. The one area in which Russia continued research and development in the 1990s was in advanced military technologies. By 2010, it will certainly have the most effective army in the region. By 2015-2020, it will have a military that will pose a challenge to any power trying to project force into the region, even the United States.

Editor's Note: Subscribers are invited to access the full text of the chapters that focused on Eastern Europe and Russia from George Friedman's 2009 book, The Next 100 Years, by clicking the links below.