Themes > Features

23.06.2002

Finance and the Real Economy : The Global Conjuncture

The preliminary edition of OECD's Economic Outlook relating to April 2002 begins on a note of optimism regarding the prospects for an economic recovery in its member countries. This recovery, which is expected so soon after the September 11, 2001 incidents that aggravated pre-existing recessionary tendencies, is characterized by three aspects. First, it is driven by an upturn in the United States that is yet to impact on many other economies, especially Japan, which has been languishing for close to a decade now. Second, even in the US, it  is stimulated by an easing of monetary policy, the maintenance of low interest rates, and by  a return to deficit-financed government spending, all of which have helped boost consumption spending. Third, there are as yet no signs that the recovery has begun to touch investment spending, especially in the crucial area of information and communication technology, which helped drive the long boom of the 1990s in the US. As a report in the June 23 issue of The New York Times put it, "While other areas are showing tentative signs of strength, technology remains in a deep funk."
 
Of these the most disconcerting to many observers is the lack of synchrony among developed countries in the timing of the upturn, if any. In fact, through the 1990s, there was no sign of any degree of synchronization of the economic cycle across the major economies. As Chart 1 shows, between 1991 and 1994, while the US and UK recorded sharp recoveries in annual rates of GDP growth, Germany, France and Japan witnessed a downturn. In the subsequent five years, only the US managed to maintain remarkably high rates of growth; performance in Germany, France and the UK ranged from moderate to good and that in Japan was dismal in almost all these years excepting 1996. It was only when the US economy lost steam early in 2001 and found itself on a downturn, that there seemed to be a semblance of synchrony. The downturn that afflicted the US now appeared to be a more generalized phenomenon, making its implications more ominous. And today, even as the post-September 11 spending spurt seems to be quickly halting the downturn in the US, the effects are less impressive in other major OECD nations.

       
 
This lack of correspondence in economic performance is even starker when assessed in terms of developments in the labour market. Unemployment rates in Germany and France rose significantly between 1990 and 1997, to touch 9.4 and 12.2 per cent respectively. Though they declined subsequently, unemployment levels in these countries are still above the 1990 mark. Unemployment in Japan rose continuously through the 1990s, though the low initial level of 2.1 per cent has meant that it still records rates close to the US and the UK. It is  only in these latter countries, the US and the UK, that unemployment rates have fallen sharply since 1992-93, though that trend has been reversed in 2002 in the US.

         
 
Thus, clearly, unlike in the four decades following World War II, when the world economy was ostensibly less integrated, the 1990s have seen a process of de-synchronization of the economic cycle in individual nations, which is visible even in the relative performance of the developed industrial nations. Not coincidentally, perhaps, the 1990s were also the years of globalization, years in which inter-country relationships were substantially mediated through financial flows. By that decade financial liberalization had ensured a build-up of liquidity at national and international levels, enhanced the flexibility of financial firms to undertake diverse operations across financial activities, provided new avenues for speculative investment in areas such as foreign exchange and derivatives markets, and rendered finance globally mobile.
 
At the most superficial level the de-synchronization of the economic cycle across developed countries may be attributed to the end of the era of Keynesian counter-cyclical policies, which the rise of finance capital implied. Greater integration through trade and financial flows meant that if any one country adopted counter-cyclical policies, it ran the risk of triggering domestic inflation, of undermining the ability of domestic firms to face up to foreign competition in local and foreign markets, of experiencing a worsening of its current account balance and a weakening of its currency, and of being threatened by a speculative attack on its currency that would be destabilizing. This is precisely what happened to France under Mitterand in the early 1980s. This loss of the ability to undertake counter-cyclical policies in isolation meant that when individual developed economies were faced with a downturn, they could not correct the imbalance by increased government spending.
 
The rise of finance capital affects the ability of governments to undertake deficit spending even directly. Finance capital is wary of the possible inflationary consequences of deficit-financed expenditure, since such inflation affects the real value of financial assets and the real rate of return on such assets. It is also wary of the possibility that governments resorting to deficit-financed expenditure may manage interest rates in a manner aimed at keeping down the cost of their borrowing requirements. Not surprisingly, financial agents constantly run down deficit-based spending and often respond by pulling out of economies characterized by high deficits on the governments' budgets. Fear of the destabilizing effects this would have puts direct pressure on governments to abjure deficit-financed spending.
 
The reality is that inasmuch as this fear of deficit spending afflicts each and every government, we should expect the adoption of a more deflationary stance across countries that could result in an overall slowing of global growth. The shift to a more deflationary stance did, in fact, occur. As Chart 3 shows, government fiscal balances in the 1990s reflect a sharp reduction in the level of deficit spending in the principal developed countries, with the exception of Japan, where the level of deficit spending increased sharply. In fact, by 1998, the fiscal balance in the US and the UK had turned positive.

          
 
It cannot be denied that this shift to a deflationary stance in fiscal policy across the major developed countries would have had an adverse impact on growth. To start with, in all these countries the stimulus to growth afforded by government expenditure would have been considerably dampened, since deficit spending relative to GDP fell in a period when tax rates were being substantially reduced to spur private initiative.  This would have been aggravated by the global effects of reduced deficit spending in the world's leading economy, the US, whose currency serves as the world's reserve currency and is therefore considered 'as good as gold'. In the decades immediately after World War II, America used its hegemonic position and the fact  that it was home to the world's reserve currency, to function as though it faced no national budget constraint. It could finance expenditures worldwide, including those on policing the world, independent of whether it had a surplus on its current account or not. It did not have to earn foreign exchange to sustain such expenditures, since the dollar was accepted in any quantity worldwide.
 
The willingness of the US to undertake such deficit-financed expenditures based on its strength as the world's leading power obviously meant that the United States served as an engine for global growth. The post-War boom in the world economy is attributable in no small measure to this tendency. Conversely, the decision of the US government to move out of a regime in which it sustained a high and persistent deficit on its budget to one in which its budget showed a surplus must have substantially worsened the deflationary tendency in the world system. The consequent tendency towards deflation is reflected in price trends worldwide (Chart 6), which point to a significant and continuous decline in inflation rates across the major industrialized nations throughout the 1990s.

        
 
These circumstances render the picture of de-synchronized economic performance during the 1990s even more puzzling. To start with, we have the counter-intuitive trend wherein the US, which saw a dramatic transition from deficit to surplus budgets, turned out to be a remarkable performer growth-wise precisely in those years in which that transition was occurring. Next, barring Japan, growth in many of the developed countries, especially the UK, was not very much worse in the 1990s than it was in the previous decades, despite the dampening effects of their own deflationary fiscal stance and that of the US. Finally, we have the unusual fact that despite the consistent effort of the Japanese government to pump-prime its economy through a series of reflationary packages, the Japanese economy performed poorly right through the 1990s, except for a brief episode of growth around 1996.
 
The first step in unravelling this puzzling set of circumstances is to recognize that in the era of finance, the stimulus to growth has to come from the private sector. Since private investors need some inducement to invest, private sector-led growth in any economy must be stimulated by a rise in consumption expenditure either in the domestic economy or abroad, which translates into increased demand for domestic firms. There is reason to believe that the rise to dominance of finance does contribute to such an increase in private expenditure. Financial flows and financial liberalization can make a self-correcting contribution to neutralizing the deflationary bias resulting from reduced government expenditure in two possible ways: (a) they can permit a burgeoning of debt-financed consumption and housing expenditures that help sustain private and public spending so long as borrowers and lenders coexist; (b) they can trigger financial developments that increase the financial wealth of households, which in turn, through the 'wealth effect' encourages consumption and even dis-saving.
 
The experience of the sample of developed countries being considered here captures the positive role that finance can play on both these counts. As Chart 4 illustrates, the annual rate of growth of private consumer expenditure has been well above average in both the US and the UK, moderately positive in France and Germany, and extremely poor in Japan. This explains in large part the relative performance of these countries, since computations made by the OECD Secretariat (Table 1) suggest that changes in final domestic demand, rather than increases in inventories or net exports, tend to explain almost all of GDP growth in the world's leading nations.

             

                         
 
Being the hub of global finance, by virtue of being home to the world's reserve currency, the US epitomizes the impact that the rise of finance can have on private consumer expenditure and the real economy. Firstly, the US was the one country in which, through the 1980s and 1990s, credit helped fuel a consumption and housing expenditure boom. Secondly, a combination of higher interest rates and confidence in the dollar, due to the US being the leader and the dollar serving as the world's reserve currency, resulted in a preference for dollar-denominated assets among the world's wealth-holders.
 
The consequent flight to the dollar, in a world of mobile finance, was self-reinforcing. To start with, the flow of capital into the US strengthened the dollar, delinking its value from real factors such as the competitiveness of US manufacturing and the deficit on the current account of US balance of payments. The stronger the dollar became, the greater was the attractiveness of US financial assets as safe investments. Further, once a significant share of the world's financial wealth was invested in dollar-denominated assets, the greater was the pressure worldwide to prevent any downturn in US financial markets and any sharp fall in the value of the dollar. Even when evidence accumulated that US financial markets were witnessing an unsustainable speculative boom, the prime concern of international finance and international financial institutions was to ensure that the necessary correction took the form of a 'soft landing' rather than a crash.
 
The movement in the New York Stock Exchange's composite index during the periods 1971-85 and 1986-91 captures the impact of these developments on the performance of US financial markets (Charts 10 and 11). In the upward climb of the NYSE index which began in the early 1980s, the annual closing high and low values of the index rose by just 50 per cent between 1980 and 1985. Maintaining a similar growth path, between 1986 and1994 these indices rose by a further 84 and 106 per cent respectively. However, during the speculative boom of the late 1990s, the high and low indices rose by 148 and 137 per cent respectively in a short span of five years, between 1994 and 1999. Subsequently, the boom tapered off, but there was no major corrective collapse in the NYSE indices during the slump years of 2000 and 2001. This partly helped prevent a collapse in the real economy, for the reasons detailed below.

           

             
 
It is now widely accepted that, because of the direct (through investments) and indirect (through pension funds) involvement of US households in the stock market, the boom in those markets substantially increased their financial wealth. This in turn is seen to have had a 'wealth effect', as a result of which households, feeling that they had saved substantially more for the future than initially planned, resorted to a splurge in consumption. Thus, in the US, the rise of finance spurred consumption directly by fuelling credit-financed spending, and indirectly through the wealth effect. As a result, the personal savings rate in the US collapsed from 8.7 per cent in 1992 to 1 per cent in 2000 (Chart 5), reflecting the growth in consumption expenditure that helped sustain the boom in the real economy. It was in this manner that the deflationary consequences of reduced government spending were more than neutralized in the US.

               
 
If everything else had remained constant this private consumption expenditure-led boom in the US should have triggered growth in the rest of the world as well. Inasmuch as US demand is serviced through imports from abroad, this is what should be expected. And both relative competitiveness and the strength of the US dollar should result in some leakage of US demand abroad. That this did happen is suggested by the facts that the boom years were ones in which world trade volumes grew at above average or remarkably high rates (Chart 7) and the deficit on the US current account widened substantially (Chart 8). In fact, there is reason to believe that the export success of individual countries like China depended on the benefits they derived from the booming consumer market in the US. But to the extent that the US remained a major player in frontline sectors like information and communication technologies and the new services, that US firms restructured themselves to improve their competitiveness and foreign firms chose to set up capacities in the US to cater to the local market, the consumption boom resulted in a real boom in the US as well.

             

           
 
What is noteworthy is that the spill-over effect of the US boom was  less visible during the 1990s than would have been expected based on past experience. Excepting for some success, however unstable, in Southeast Asia and China, growth was either moderate in the other industrial nations (barring the UK) or dismal, as in Japan and large parts of the developing world. The reasons are not hard to find. France, Germany and the UK were not major beneficiaries in terms of a net export boom. Whatever growth occurred there was based on an expansion of final domestic demand. Also, in these countries, the stimulating effect of financial flows on stock market values and the extent of involvement of households in the stock market were far less than in the US. Thus one of the principal ways in which a financial boom translates into a real boom, was far less effective in these countries.
 
But that is not all. In countries such as Japan and even in many developing countries like South Korea, which have predominantly bank-based rather than stock market-based financial systems, financial liberalization has proved debilitating. In these countries, the high growth of the 1970s and 1980s was fuelled by bank credit, which allowed firms to undertake huge investments in capacity and diversify into new areas where world trade was booming, in order to garner the export success that triggered growth. The consequent high levels of gearing of firms and high exposure of banks to risky assets could be 'managed' within a closed and regulated financial system, in which the state, through the central bank, played the role of guarantor of deposits and lender of last resort. Non-performing loans generated by failures in particular areas were implicitly seen as a social cost that had to be borne by the system in order to ensure economic success.
 
Such systems were rendered extremely vulnerable, however, once liberalization subjected banks to market rules. And when, in a post-liberalized financial world, vulnerability threatened the stability of individual banks, the easy access to liquidity, which was so crucial to financing the earlier boom, gave way to tight financial conditions that spelt bankruptcy for firms and worsened the conditions of the banks even further. At the beginning of 2002, the official estimate of non-performing loans of Japanese banks stood at Y43,000 billion, or 8 per cent of GDP. This, despite the fact that over nine years ending March 2001, Japanese banks had written off Y72,000 billion as bad loans. In the past this would not have been a problem, as it would have been met by infusion of government funds into the banking system in various ways. But under the new liberalized, market-based discipline, banks (i) are not getting additional money to finance new NPAs; (ii) are being required to pay back past loans provided by the government; and (iii) are faced with the prospect of a reduction in depositor guarantees, which could see the withdrawal of deposits from banks.
 
With banks unable to play their role as growth engines, the government has been forced to use the route of reduced interest rates to fuel growth. This has affected banks even further. With interest rates close to zero, lending is not just risky because of the recession, but downright unprofitable. As a result, despite government efforts to ease monetary conditions, credit is difficult to come by, adversely affecting investment and consumption.  The net effect is that financial liberalization has triggered a recession that consecutive rounds of reflationary spending by the state have not been able to counteract.
 
In other situations, as in South Korea and Thailand, financial liberalization had permitted the financial system to borrow cheap abroad and lend costly at home, to finance speculative investments in the stock market and in real estate. When international lenders realized that they were overexposed in risky areas, lending froze, contributing to the downward spiral that culminated in the 1997 crises in Southeast Asia. In the event, deflation has meant that, a recovery in some countries notwithstanding, the current account of the balance of payments in developing countries reflects a deflationary surplus in recent years (Chart 9).

           
 
Thus, in countries which do not have the US advantage of being home to the reserve currency and have a financial system that is structurally different, the rise of finance has implied that that the underlying deflationary bias in the system induced by financial mobility has been worsened in more ways than one. If we add this tendency towards depression in parts of the world to the limited and countrywise concentrated spill-over of the US boom into world markets, it becomes clear that the de-synchronization of the economic cycle across countries during the 1990s is a fall-out of the rise to dominance of finance internationally.