MOHAN GURUSWAMY | 30 MAY, 2016
Deficit of Trust Pushes Global Economy Into a Tailspin
NEW DELHI: The crisis in the global economy is a subject that engages many and affects most of mankind. Like all such issues we find little clarity but a lot of fire and brimstone.
Few have tried to seek feasible solutions. Even fewer are qualified, experienced and with a usefully cosmic view of the world we live in to write about it.
Fortunately we still have people like Mervyn King. King was the Governor of the Bank of England from 2003 to 2013, a tumultuous period that saw the world economy expand at a record pace and then arrive at the precipice in 2008. We are still seeking to find new pathways to get over it. And clearly we are struggling.
We are now increasingly a world where trust is in deficit. Countries don't trust each other. People don't trust their governments. Government’s don’t trust their regulators. Regulators don't trust the banks and the financial community. But above all governments don't trust the people will support them to do the right things. But as King writes: “Trust is the ingredient that makes a market economy work. It is central to the role of money and banks, and the institutions that manage our economy.” How do we find trust again often seems to be the main issue of our time.
Raghuram Rajan recently wrote: “Politicians know that structural reforms – to increase competition, foster innovation, and drive institutional change – are the way to tackle structural impediments to growth. But they know that, while the pain from reform is immediate, gains are typically delayed and their beneficiaries uncertain.
As Jean Claude Juncker then Luxembourg’s prime minister, said at the height of the euro crisis, “We all know what to do; we just don't know how to get re-elected after we’ve done it!”
But let us step back a bit and try to understand why and how we are in this situation?
Imagine living on an island as a part of a small group, each of whom is assigned a specific vocation and task. In this system one-person makes clothes, another shoes, someone pots and pans, some one grows food and someone else prints money to facilitate exchange of goods and services. So the shoemaker exchanges his goods with another for money and in turn pays with that money for food or whatever.
Since everybody in this system can produce as much as possible, the person who prints the money will be best off among all because he can buy whatever he wants and pay for it with his own money.
Take this one step further then. Producers who come to hold more paper than they need then start leaving it with the person who prints them to hold and lend. Expand this to the global scale and we pretty much have something similar to the world system.
In 2016 the World GDP totaled about $77.83 trillion. In 1960 the WGDP was $6.85 trillion (1990). The WGDP was just $1.1 trillion in 1900 and took half a century to grow fourfold to $4.01 trillion and grew ten fold in the next fifty to $41 trillion (1990). The big leaps began after 1971 when US President Richard Nixon unilaterally delinked the US dollar from the international gold standard.
Now let’s turn to see how the system actually works. The emerging countries produce goods and services at the lowest costs for consumption in the US, which in turn pays them in dollars, which they in turn deposit in US banks. Give or take a little.
Since money cannot sit still, this money in US banks is then lent to Americans, who today have the highest per capita indebtedness in the world, to splurge on houses, cars, HD TV’s, computers and playstations, which they can often ill-afford.
The cumulative debt of US households is now $11.4 trillion. Credit card debt alone of each US household is about $15000. There are 160 million credit cards in the US. The USA accounts for a quarter of the WGDP and the world keeps two thirds of its in US dollars. Quite clearly the US finances, public and personal, are out of control.
The irony is that this is well understood, but like the people who kept investing with Bernard Madoff, countries like China, Russia, Japan, Kuwait, India and others keep investing in US securities at interest rates mostly between 1-2%. Thus, in effect the rest of the world was plying the US with cheap credit, encouraging it to splurge even more.
Unfortunately there was and is no global regulator to caution the US on its profligacy or force it to mend its ways. There is also no global regulator who can ensure that countries like China balance their trade. Thus, it is US profligacy and Chinese surpluses parked in US banks that are the biggest cause of this dysfunction. Many have described this relationship as akin to that of a drug addict and a drug peddler. The drug addict is now in rehab and it’s the peddler who is suffering from withdrawal!
At the Breton Woods Conference of July 1944 that took place under the fast receding shadow of WWII, Lord Keynes had in mind an elaborate scheme that called for the establishment of an international reserve currency. But this had to be shelved in the face of American obduracy.
Keynes' proposals would have established a world reserve currency called "Bancor" to be administered by a international Central Bank. This Central Bank would have been vested with the responsibility of creating money and with the authority to take actions on a much larger scale. In case of balance of payments imbalances, Keynes recommended that countries with payment surpluses should increase their imports from the deficit countries and thereby create foreign trade equilibrium.
But the United States, as a likely creditor nation, and eager to take on the role of the world's economic powerhouse, baulked at Keynes' plan and did not pay serious attention to it. The U.S. contingent was too concerned about inflationary pressures in the postwar economy, and White saw imbalance trade as a problem of only the deficit country.
But the fact that the US has been the world’s biggest deficit country for several decades and with increasing deficits with most countries seems to have eluded the IMF. This and the fact that the US dollar has become the world’s preferred reserve currency is now the core of the world’s greatest financial problem.
This international system was unilaterally abrogated when in 1971 US President Richard Nixon US delinked the dollar from the gold standard. In the absence of a standard and a useful regulatory function for the IMF the great private banks on Wall Street were given a license to run amok. We are now reaping the bitter harvest.
With the US dollar as the world’s preferred reserve currency, the US and it’s even more profligate citizens have an apparently endless access to easy credit to satiate their sundry appetites. In this way the ever growing annual US trade deficit becomes the de facto engine of growth for many export dependent economies, such as China, Germany and the ASEAN countries.
In Chapter 7 King poses the query “how can we regain the innocence and trust in banking that, as described in Chapter 3, was lost over a long period in which crises became accepted as an inevitable feature of the financial landscape?” Yet he offers little by way of solutions.
Earlier this year, Raghuram Rajan, the Governor of the Reserve Bank of India, wrote: Arguably, what I have in mind will eventually require a new international agreement along the lines of Bretton Woods, and some reinterpretation of the mandates of internationally influential central banks. Setting the rules will take time. But the international community has a choice. We can pretend all is well with the global monetary non-system and hope that nothing goes spectacularly wrong. Or we can start building a system fit for the integrated world of the twenty-first century.”
The Audacity of Pessimism is the title of the final chapter, and with good reason. Democracy, national sovereignty and economic integration find themselves incompatible. People choose according to their immediate needs and lights, and mostly swayed by manufactured perceptions. The people’s faith in the market to generate prosperity is severely corroded. King just leaves us wondering if it’s a failure of individuals, institutions or ideas? Or all three? He plaintively asks for “an intellectual revolution”. But such revolutions only follow a cataclysmic crisis. Then there are other new realities.
The post Cold War era has seen the economic and political rise of a host of nations, Brazil, China and India being foremost among them. Each one of these nations is now a major economic player with bigger GDP’s than many in the G-7. The economic balance of power is shifting towards Asia.
Jim O’Neill, the Goldman Sachs economist who was first to coin the acronym BRICS, how predicts:“It's likely that the combined GDP of the four big BRIC nations will exceed that of the G-7 by 2020.” Since the USA and Europe do not see it as being in their interest to reform the system, it devolves upon these world growth engines to bring more order into the world system. Like Communism the ideology of the Washington Consensus has also been proved to be a failure.
Given his stature and the reputation he enjoys, Mervyn King could have used the masterly analysis of the ills to make bold and innovative proposals to get us out of this situation. He ventures: “another crisis is inevitable, and the failure to tackle the disequilibrium in the world economy makes it likely that it will come sooner than later.” Mervyn King’s book is masterly about how we came to this pass.
But curiously for a man with his experience and stature, he offers no solutions. But that may be because he knows better. Or does just lack the audacity?
The End of Alchemy: Money, Banking and the Future of the Global Economy by Mervyn King.
Hardback ISBN 978-1-4087-0610-7
Trade Paperback ISBN 978-1-4087-0611-4