The Next Global Boom – and Bust

Simon Johnson
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WASHINGTON, DC – The mood at the International Monetary Fund-World Bank spring meetings here earlier this month was grim. The latest IMF forecast for global growth has been revised downward yet again – suggesting the world will grow at an annual rate of just over 3% this year and again in 2017.
 
If realized, this would be a dismal performance. Before 2007, global growth (using the IMF’s methodology) was in the 4.5-5% range, based on steady productivity improvements in industrial countries and rapidly rising living standards in large emerging markets such as China, Brazil, and Russia.
 
Now the US faces the uncertainty of a presidential election, weaker parts of the eurozone continue to struggle, and Japan is teetering on the edge of outright economic contraction. Brazil is in the midst of a political crisis, China is dealing with the aftereffects of prolonged fiscal expansion and explosive growth in its shadow banking system, and lower commodity prices are undermining economic performance in many other emerging markets. On top of all this, the British may vote in June to leave the European Union.
 
Economic activity is affected by confidence: Do consumers believe their incomes are likely to rise (or even prove secure), and do companies believe that future growth will be buoyant enough to warrant current investment? And today’s macro mood is shared pessimism.
 
Yet the medium-term scenario is unlikely to be global stagnation. New technologies continue to be invented, and billions of people aspire to improve their standard of living through education and hard work. Leading industrial economies have demonstrated remarkable resilience in the face of large negative financial-sector shocks over the past decade – as has China.
 
Unemployment in the United States is down to 5%, and parts of Europe are doing fine. And the most important point about the commodity price cycle is that it is indeed a cycle: Demand for commodities rises and falls, while supply changes only slowly. We should expect volatility in commodity prices – as well as in the price of oil.
 
The biggest question is whether we can get off the economic roller coaster and return to robust global growth without debt-fueled overconsumption (as seen in the pre-2008 US), overinvestment (as in China), and overexpansion of government spending (still an issue in some parts of Europe).
 
Debt can fund productive investments and improvement in human capital. But why do we always seem to like it too much? Part of the reason stems from tax systems, which in some countries allow some consumer interest payments (for example, mortgages in the US) to be deducted from taxable income. Corporate interest payments are typically deductible, too.
 
But the main appeal of debt is that it is a very simple contract: Either you pay the agreed amount or you don’t. And when things go well, a highly leveraged enterprise – a company or your house – will show a great return on equity. But those returns are not risk-adjusted, which means that when the economy slumps, big losses are allocated – as American homeowners learned in 2008, Korean conglomerates learned in 1997, and governments in emerging markets learn repeatedly.
 
Policymakers know that excessive debt brings financial fragility, of course, and some efforts at reform over the past decade have aimed to scale back leverage. But financial reform is hard to do during a slump, when the main task is to revive growth. Official intentions often remain just that; time and again, political leaders find it easier simply to keep in place the existing system of rules, incentives, and guarantees. And, because large financial firms do very well with a great deal of leverage, they continue to devote abundant lobbying resources to resisting efforts to ensure that they are better capitalized (with more shareholder equity relative to their total balance sheets).
 
Indeed, the largest banks in the US – but also in most other countries – are even bigger today than they were before 2008. All candid accounts indicate their internal incentives are not much changed, and restrictions on their activities are unlikely to prove effective as global growth picks up.
 
In the US, officials hold out hope that the largest financial firms will eventually be forced to comply with a provision of the 2010 Dodd-Frank financial reform legislation requiring that they draw up credible “living wills.” Yet most big banks have repeatedly failed to produce plausible plans explaining how they could fail in bankruptcy without any government assistance and without damaging the world economy, and none has faced meaningful consequences for noncompliance.
 
Growth will return. Entrepreneurs will start new companies, and they will fund their risk-taking with equity investments provided by venture capital funds. Established nonfinancial firms have learned the hard way that they need to be careful with leverage and keep large cash cushions.
 
It’s the big banks that continue to prefer being highly leveraged. And too many policymakers are deferring to them. Like it or not, that means we are in line for another stomach-turning round on the global economy’s wild ride.
 
 
 

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