October 14, 2009, Presentation at the World Knowledge Forum, Seoul, South Korea
Starting from the middle of the world's worst economic downturn since the Great Depression, it might seem difficult to be optimistic about the prospects for the global economy. However, with sound economic policy, some of which is already in place, the recession will soon be ending and the world economy could be on a path to a solid recovery. The world in general, and East Asia in particular, should be far wealthier in a decade than it is today.
I will briefly outline what I see as the most likely path of growth in the next decade. I will emphasize the growing importance of China in the world economy. By most measures, China is likely to eclipse the United States as the preeminent world economic power over the course of the next decade. Its dominance will only increase further in subsequent years. There seems far too little appreciation of this fact in discussions of economic policy.
I will also discuss some of the major risks to world economy over this period. I will outline what I see as the three greatest dangers to the world economy:
1) The risk of the world following a "bad" trade path involving increased exports of manufactured goods to the wealthy countries and increased protection for intellectual property rights in both wealthy and developing countries.
2) The risk of prolonged stagnation due to excessive concerns about fiscal deficits;
3) The risk of more asset bubbles in the years ahead.
I will discuss each of these issues in turn.
East Asia's Turn to Lead
Old habits die hard, and that is perhaps nowhere more true than in economics. The United States has been the world's pre-eminent economic power at least since the end of World War I and arguably even prior to the war. As a result, the world has become accustomed to look to the United States for leadership, both because the size of its economy ensured that its actions would have an enormous impact on the world, and also because its views on economic policy were given extraordinary deference by policymakers elsewhere.
After having been #1 for so long, the habitual deference of others to the United States may persist for some time, but the basis for it in the world is rapidly disappearing. The fast growing economies of Asia, most obviously China and India, are rapidly catching up to the United States in absolute size, even if they still lag behind in per capita GDP. Over the next decade, the absolute amount of growth in these economies will be comparable, if not larger than the growth in the United States.
Figure 1 shows the absolute amount of growth projected for the United States over the next decade by the United States Congressional Budget Office. It shows growth for China and India under the alternative assumptions that growth averages 7 percent, 8 percent, and 9 percent over this decade. This chart uses an exchange rate measure of GDP, simply converting China and India's GDP into dollars at current exchange rates. In the 7.0 percent growth scenario, the $7.1 trillion in growth projected for the United States is approximately 40 percent more than the $4.8 trillion in growth projected for China and nearly 4 times the $1.8 trillion in projected growth for India.
If India and China manage to average 9.0 percent growth over the decade then the gap in the growth projected for the countries is considerably smaller. The $6.7 in projected growth for China is almost 95 percent of the growth projected for the United States. India's $2.5 trillion in growth will be considerably more than one-third of the projected growth for the United States. In assessing the relative plausibility of various growth paths, it is worth remembering that in the five years before the onset of the crisis, annual growth in India averaged 8.6 percent. In China, growth in the five years from 2002 to 2007 averaged 11.0 percent. So, if these countries manage to resume their pre-crisis growth path, they are more likely to be at the high end of these numbers.
Figure 2 shows the same growth comparisons using a purchasing power parity measure of GDP. In principle, purchasing power parity measures of GDP compare output using a common set of prices for all goods and services, regardless of where they are produced. In other words, a specific car, an article of clothing, a pound of beef, etc. should all be counted at the same price, even if they are actually sold at very different prices in the United States, China, and India. In principle, this would give us a much better basis for comparing the wealth of different countries, which is not distorted by fluctuations in exchange rates.
As a practical matter, measures of purchasing power parity are extremely difficult to construct. While we can match up many goods in the United States or China to their counterparts in other countries, they are many items for which no easy comparisons are possible, most importantly housing. There is no simple way to construct a comparison of the value of housing in Beijing with the value of housing in New York City or Des Moines, Iowa. However, problems also arise with a wide range of goods and services that are not strictly comparable across countries. For this reason, there is a wide range of error in measures of purchasing power parity. Nonetheless, if we are interested in measures of GDP that reflect living standards and productive capacities, clearly purchasing power parity is a better measure than exchange rate measures of GDP.
The growth projections on a purchasing power parity basis show a very different picture than the exchange rate measure. Even assuming a 7.0 percent average growth rate, China's $8.1 trillion in growth over the course of the decade would considerably exceed the growth projected for the United States. The $3.7 trillion in growth projected for India, assuming a 7.0 percent annual growth rate, is more than half of the projected growth for the United States. If China and India average 9.0 percent growth over the next decade, then the growth projected for China is almost 50 percent more than the growth projected for the United States. The $4.3 trillion in projected growth for India is approximately 60 percent of the growth projected for the United States.
It is worth noting that the World Bank recently constructed a new set of purchasing power parity measures that showed much lower measures of GDP for many developing countries, especially China and India. If we use growth projections that rely on the old purchasing power parity measures of GDP, then we get a dramatically different picture of the relative size of the three economies and their growth paths over the next decade.
Figure 3 uses the pre-revision purchasing power parity measures. With these measures China's growth would be almost double that of the United States in the next decade even if its annual growth averages just 7 percent. In this case, the $5.1 trillion in projected growth for India would be more than 70 percent of the growth projected for the United States. If China grows at a 9 percent annual rate over the next decade, the pre-revision purchasing power parity numbers would imply that its growth would be almost three times as large as the growth of the United States over this period. Using the pre-revision data, at a 9.0 percent annual growth rate, India's growth would also exceed that of the United States over the next decade.
Of course, the World Bank's puts considerable effort into the construction of its purchasing power parity measures and it is reasonable to presume that its updated measure is better than the pre-revision measure. Nonetheless the new measure does lead to some peculiar conclusions. For example, if we start from the current measures of purchasing power parity GDP, and then calculate purchasing power parity measures of per capita income for China and India in 1980, based on growth data for the last 3 decades, we find that both countries would have been incredibly poor in that year.
As shown in Figure 4, this calculation gives India a per capita income in 1980 of just over $900 (in 2009 dollars) and China a per capita income of approximately $550. By comparison, Ethiopia currently has a per capita income of about $950, slightly higher than the figure calculated for India for 1980 and almost 80 percent higher than the figure calculated for China. Afghanistan has a per capita income of more than $800 presently, slightly less than India's 1980 per capita income and close to 60 percent more than China's income. Liberia, a country wracked by civil war and corruption, almost alone manages to fall below the per capita GDP calculated for China in 1980. The figure shows per capital income for Kenya and Tanzania in 2009 are close to three times the per capita income calculated for China in 1980 and nearly twice, in the case of Kenya, the per capita income calculated for India in 1980.
Of course this seems implausible. China and India were much poorer in 1980 than at present, but even then both were countries in which the overwhelming majority of the population was literate and life expectancies were well past 60. By almost any measure of social well being these countries would have placed far above the best performers in Sub-Saharan Africa today, not among the very worst, which is implied by this GDP data.
If the purchasing power measures of GDP and the growth data produce seemingly implausible results when carried backwards, it is certainly possible that the problem is with the growth data and not the measures of purchasing power GDP. However, it is possible to make some crude comparisons to get some sense of the relative size of the economies. (I'll just focus on China and the U.S. in this discussion.)
Figure 4 compares the number of Internet users in the two countries. China, with almost 350 million Internet users has 50 percent more users than the United States.
Figure 5 shows car sales for the first 8 months of 2008. Over this period, China's population purchased approximately 10 percent more cars than the population of the United States. Of course, the U.S. is in the middle of an extraordinary downturn and car purchases are highly cyclical, so it is certainly possibly that the U.S. may again surpass China in car purchases. The average car bought in the U.S. is also a higher quality car than the average car purchased in China, nonetheless the total value of sales in the two countries must be getting close. (According to iSuppli, a marketing research company in the United States, China passed the United States in car production in 2008 and will produce approximately 20 percent more cars than the United States in 2009.)
Figure 6 shows projections for 2010 of the number of college graduates in science and engineering for China and the U.S. China is projected to graduate 20 percent more students in these fields next year. It is also worth noting that these figures show graduates at domestic universities. Many students studying in the United Students are not U.S. nationals and will not remain in the United States after graduation.
Figure 7 shows the number of cell phone users in each country. With almost 650 million cell phone users, China has more than twice the number of cell phones users as the United States.
There are many other comparisons that would show China ahead of the United States, often by large amounts. China produced more than 5 times as much steel as the United States last year. It produced and used more than 10 times as much cement.
And, it is not just low-tech items where China seems to moving ahead. Isuppli projects that China will account for more than 17 percent of worldwide production of polisilicon, the main input into solar panels, in 2009. It is projected to account for more than 25 percent of worldwide production of panels. It is currently installing wind energy at a far more rapid pace than the United States and some projections show it producing as much as 100 gigawatts of wind energy by 2020, far more than twice as much as even the most ambitious targets for the United States.
Again, there is wide range of uncertainty in purchasing power parity comparisons of GDP, but the official data, which place China at just over half of the U.S. level of output, simply do not seem plausible. China's output must stand somewhere close to that of the United States in 2009 (as the pre-revision data show), and is almost certain shoot pass the United States over the course of the next decade. The time frame for catching up in sectors where the U.S. currently enjoys an advantage is likely to be measured in years, not decades.
What this means for the world is that there is likely far too much time spent worrying about the United States and far too little time focusing on China. Although exchange rate measures of output may be more important at a moment in time for many purposes, at the end of the day, an economy's productive capacity will determine its importance in the world economy. For example, China's demand for oil and other raw materials will depend on its productive capacities, not its exchange rate GDP. The same is true of its ability to export a wide range of goods and services. (Using the exchange rate measure, China exported almost 8 percent of its GDP to the United States in 2008.)
In comparing the relative importance of China and the United States over the next decade it is also worth noting that the United States has a huge trade deficit (temporarily depressed as a result of the economic downturn) and China has a huge trade surplus. It is reasonable to expect both countries to move somewhere close to a trade balance over this period. This means that imports to the United States will grow less rapidly than would ordinarily be implied by its growth over the decade, whereas imports to China are likely to grow considerably more rapidly. In other words, countries looking for an export market in the decade ahead would probably be advised to focus much more on China than on the United States.
Given China's extraordinary savings rate, it is already and will continue to be the largest single source of capital in the world. How it chooses to use this capital will also have an enormous impact on the world economy.
To sum up my positive picture, there is every reason to believe that China and the rest of East Asia, along with India, can resume the extraordinary growth path they had prior to the onset of the crisis. In fact, the success of the stimulus in China in sustaining a healthy rate of growth even through the worst period of the downturn suggests that China has far more ability to steer its economy than had generally been appreciated and certainly far more ability than most of the wealthy countries. China's economy appears to be fast growing and flexible. At the moment at least, it would appear to have a very bright future. And its prosperity is likely to provide a substantial boost to the growth prospects of the other countries in the region.
Major Risks Facing the World Economy
Having warned about the imminent collapse of the housing bubble in the United States for the last seven years, I am used to telling gloomy tales about the economy. While I actually think that there are considerable grounds for optimism about the world economy, primarily due to the strength of India and the East Asian economies, there remain grounds for serious concern. As I outlined at the beginning of my talk, I will discuss three troubling scenarios.
The Bad Trade Path
The first is one that I have dubbed "the bad trade path." This is pretty much the trade path that the United States at least is currently following. The United States has an enormous deficit on it merchandise trade, which is only minimally offset by a modest surplus in services. The merchandise trade deficit is especially pernicious in the case of the United States because it has let to a massive decline in manufacturing employment. That is important in the United States because manufacturing has historically been a source of relatively high paying jobs for workers without college degrees (roughly 70 percent of the workforce).
Over the last three decades, the United States has seen a substantial widening in the pay gap between workers with and without college degrees. There are many factors that have been cited as contributing to this pay gap, but trade, and specifically the loss of manufacturing jobs, has certainly played a role. Manufacturing jobs accounted for 21.5 percent of the workforce 30 years ago, they now account for less than 9.0 percent.
In addition to the direct impact that the loss of manufacturing has on the pay structure, it has also been an important factor in the decline of unionization. In the early 80s, the unionization rate in manufacturing was over 30 percent; almost double the share for the economy as a whole. The loss of manufacturing jobs has disproportionately affected unionized workers. The unionization rate among manufacturing workers is now just 11.4 percent. This means that trade has weakened unions by both substantially reducing manufacturing employment and by reducing the share of the sector that is unionized.
The decline of unions also has an enormous impact on political make-up of the country, in addition to the impact that the reduction in union power has on the labor market. Unions have been enormously important in pushing for a wide range of welfare state measures, such as universal health care, family leave for workers with young children, and the protection of the public Social Security system.
If the country suddenly lost its unions, so that the workforce was 100 percent non-union, politics in the United States would be hugely different. In the 2008 presidential election, there is no doubt that Senator McCain would have won by a large margin without the influence of the unions. I don't want to drift too far from economics, but I think it is fair to say that the United States would act very differently in world affairs, if unions ceased to be an important force in its domestic politics.
If Al Gore had become president in 2000, he probably would not have invaded Iraq in 2003, adopted "enhanced" interrogation methods, or refused to cooperate with international efforts to reduce greenhouse gas emissions. I should also mention that what applies to the U.S. also applies to Europe, although unions are so firmly entrenched in the political structure of Europe it is less plausible to envision a scenario that drives them from the political stage.
There is also a bad economic story that can be told for East Asia and the rest of the developing world from continuing down the current trade path. One of the main concessions that the United States seeks in every round of trade negotiations it enters is enhanced protection for patents and copyrights and other forms of intellectual property. This is the result of the enormous political power wielded by the pharmaceutical, entertainment, and software industries.
These forms of protection can be enormously costly. While tariffs and quotas rarely rise the price of items by more than 30-40 percent above their competitive market price, intellectual property rules often raise the price of items by several thousand percent above their competitive market price. Figure 8 shows projected expenditures for prescription drugs in the United States for 2009 and compares them with a rough calculation of the cost in a competitive market. Our Department of Health and Human Services projects that we will spend almost $250 billion (approximately 1.7 percent of GDP) on prescription drugs this year. By contrast, if these same drugs were sold as generics without patent protection, the cost would likely be in the range of $25 billion.
This huge gap leads to an enormous deadweight loss, as many people do not get the best drugs for their condition, because they cannot afford them. Perhaps a bigger cost is the bureaucracy involved in sifting through insurance claims to verify that expensive drugs are actually needed for specific conditions.
However, the biggest cost is probably the bad medicine that results from rent-seeking behavior by drug companies. When drugs sell for as much as a thousand times their marginal cost of production, drug companies have enormous incentive to mislead doctors and patients about their usefulness. As a result, the drug companies routinely put out misleading information about the effectiveness of their drugs and conceal results that reflect badly on them. Medical journals are in a constant battle to exclude ghost authored pieces in which drug companies pay researchers to submit articles under their own names.
The United States is the only country at present that gives the pharmaceutical industry essentially unfettered patent monopolies, allowing them to charge whatever price the market will bear – when the government excludes competition. However, the pharmaceutical industry wants to use the prize of better access to the U.S. import market as wedge to increase the strength of protection in other countries. The entertainment and software industries have the same idea. There is a plausible trade path in which these industries succeed in pressing this agenda and force the same sort of strict patent and copyright protection on other countries. This could imply enormous economic losses for U.S. trading partners, as well as a substantial deterioration in the quality of their health care systems.
The Budget Deficit Obsession
The second dangerous scenario is one that I have dubbed the budget deficit obsession. The basic story is that the United States, and potentially many other countries, get locked onto a course in which they obsess over the size of their deficits, rather than stimulating their economies. In the U.S. case this can mean many years in which the economy operates at levels of output that are well below full employment.
The basic story is very simply. The United States was running a very large trade deficit, prior to the onset of the recession. The recession has brought the trade deficit down considerably, but it would almost certainly bounce back to at least 5 percent of GDP and possibly more than 6 percent of GDP if the U.S. economy fully recovered.
A deficit of this size implies that the United States is borrowing huge amounts from abroad. As an accounting identity foreign lending is equal to national savings, or in this case, foreign borrowing implies that national savings must be negative. This means that because the United States has a large trade deficit, it must either have a large budget deficit (meaning low public savings), a low private saving rate, or some combination.
For the moment, let's assume that the private saving rate remains at near normal levels. (We could get bubble-induced consumption, but that will be dealt with in my next scary scenario.) This means that the only way for our accounting identity to hold is with a very large budget deficit. In other words, if the United States is going to run large trade deficits, then it will also have to run very large budget deficits.
However, suppose that political pressure and/or pressure from financial markets prevents the United States from running large budget deficits? In this case, the trade deficit would adjust through a reduction in output. In other words, a lower budget deficit will reduce employment and income, and it will also reduce imports. This would means a lower trade deficit.
That is one way to make the books balance, but one that would look very bad in the United States and not especially good for its trading partners. In the case of the United States, this scenario would condemn the workforce to a prolonged period of high unemployment. Tens of millions of workers could find themselves facing long spells of unemployment and/or underemployment. In a society with a very weak social safety net, and one that is designed around support for people with jobs, the prospect of a prolonged period of high unemployment is quite scary.
This scenario should not look very good to U.S. trading partners either. The implication is that the U.S. economy will be operating well below its capacity level of output for a long period of time and that it will experience a substantial period of very slow growth. Those countries hoping that the U.S. would provide a large and growing market for their exports will be severely disappointed. The countries investing in dollars to in order keep the value of their own currencies from rising will inevitably see the bad story that many claim to fear: at some point the dollar will fall in value and they will lose large amounts of money on their dollar holdings. If getting a reasonable and secure return on investments is a concern, then buying up large quantities of an over-valued currency is not a wise path to follow.
Of course the way to avoid this particular bad scenario is to allow the value of the dollar to fall to a level that is consistent with more balanced trade at full employment levels of output. This would involve a temporary reduction in the size of the export market that the U.S. provides. It also would mean somewhat greater import penetration of U.S. made products. However, in the long-run, it should lead to a much stronger growth path for both the United States and its trading partners.
The Asset Bubble Scenario
Perhaps the most scary scenario involves the potential rise of another asset bubble in the wake of the collapse of the housing bubble in the United States and other countries. Of course we all should know better and be prepared to head off another bubble before it grows to dangerous proportions, but that was also true in 2002 when the housing bubble in the United States first began to reach dangerous proportions.
As things stand, nothing in the fundamental structure of the U.S. financial system has been changed to make another bubble less likely. In fact, some of the changes could make another bubble even more likely.
At the top of this list would be the greater concentration within the banking system and the formalization of the "too big to fail" doctrine. There had been a substantial increase in the concentration of banking in the United States over the last three decades, as state and federal regulations designed to limit banks' size were weakened or eliminated. As the system now stands four major banks (Citigroup, Bank of America, J.P. Morgan Chase, and Wells Fargo) each hold close to 10 percent of the deposits of the entire national banking system.
The most recent wave of consolidation came about as a direct result of the crisis. All of these banks were given incentives to absorb failing competitors. In the crisis atmosphere that existed over most of the last year and half, government regulators chose to ignore instances in which mergers or takeovers would violate the remaining restrictions on concentration.
In addition to being more concentrated, the too big to fail doctrine has now essentially been adopted as official policy. It is almost inconceivable that the government would allow one of these four giants or several other major financial institutions to go into bankruptcy.
The Obama administration has proposed a new set of regulations that would enshrine these institutions as "too big to fail," but offset the advantages this protection offers in credit markets with increased capital requirements and greater restrictions on risk-taking. The prospects for this legislation are uncertain at this point. For the time being this means that we have several too big to fail institutions – which thereby have much greater access to credit markets – but no corresponding increase in regulatory scrutiny. This is a very dangerous situation.
Another contributing factor to this third bubble scenario is that bank executives continue to have enormous incentive to engage in risky trading activity. While there have been proposals put forward by the Obama administration and others to change the form and possibly size of compensation packages in the financial industry, nothing has been put in place thus far. The banks appear uninterested in changing their pay patterns and, unless their hand is forced by the government, they most likely will not change their behavior.
This has been seen most clearly in the behavior of Goldman Sachs. Even though at the peak of the crisis, it changed its status from an investment bank, regulated by the Securities and Exchange Commission, to a bank holding company, regulated by the Federal Reserve Board and the Federal Deposit Insurance Corporation (FDIC), it does not appear to have changed its behavior at all. After it changed its status, it quickly took advantage of an emergency program to borrow $28 billion with an FDIC guarantee. Goldman continued to act like an investment bank, actually increasing the risk of its trading positions compared to the pre-crisis period. With many of these bets having paid off, Goldman is now planning to pay out $9 billion in bonuses this year. Given the brazenness of this example, there is little likelihood of any changes in the structure of executive compensation in the financial industry, without a major political push from President Obama.
The third cause for concern is that there is no reason to believe that regulators in the United States have gotten any smarter or more courageous about confronting the financial industry. One of the biggest failings of the response to the financial crisis is that none of the regulators were held responsible for allowing the bubble to grow unchecked. In fact, Federal Reserve Board chairman Ben Bernanke, the person with the greatest responsibility for this failure after Alan Greenspan, is being reappointed as Fed chair to near universal praise. There is probably no one in any regulatory agency that has even missed a promotion after this disastrous failure of regulator policy and certainly there are no obvious examples of regulators who have lost their jobs.
This point is important, because it will always be difficult for regulators to confront powerful financial interests. The major banks all have important contacts in the executive branch and Congress. If a regulator seeks to crack down on risky, and profitable, actions by a bank, then it is a virtual certainty that the bank will use its full political power to have the regulator over-ridden. This is likely to lead regulators into unpleasant confrontations. At the least, these confrontations are likely to prove bad for their career prospects. If a regulator persists in challenging a powerful bank, it could even cost them their job.
That will always be the case in Washington, at least for the foreseeable future. However, we would expect better behavior from regulators if they knew that there would be consequences from not doing their job as well. In other words, if a regulator failed to crack down on a bank's risky behavior, and the result of this failure turned out to be costly for the government and/or the economy, then a regulator should face serious disciplinary measures. This would provide some balance to the structure of incentives that regulators face.
The recent crisis was the result of enormous regulatory failures at all levels. Yet, no regulators are suffering any consequences. This means that when future regulators see the need to clamp down on a powerful bank, we can assume that they will not do so, if they respond rationally to the incentives they face on the job.
The final reason that we should fear another bubble, at least in the United States, is that it is likely to be the easiest way to boost growth. Getting more stimulus will be a hard sell politically and it seems that the Obama administration may have already abandoned the second stimulus option. A lower dollar would provide a substantial boost to exports, but there seems little will to push in this direction either.
If the two obvious options for promoting growth are closed off, then another bubble looks especially inviting as a third option. It is not clear what form another bubble would take. Apart from the stock market and housing, it is not clear that there is another market large enough that it could provide a serious boost to growth if it was caught up in a speculative bubble, but perhaps bubbles in multiple markets – say several important commodities -- could do the trick. However, since there is still so little honest discussion of the stock and housing market bubbles in policy debates, it is certainly possible that one or both of them could be re-inflated. Needless to say, there will be no shortage of "experts" to tout the run-up in prices in these markets if they began to again diverge from fundamentals. It is not as though any economist ever loses their job, or even their credibility, by failing to see a bubble.
In short, we should view the U.S. economy as being highly vulnerable to another bubble. All the forces that led to the last two bubbles are still in place and there is no mechanism in place that would necessarily act to prevent the rise of another dangerous bubble.
I remain optimistic about the overall course of the world economy. It is inspiring to see hundreds of millions of people in Asia moving out of poverty, or near poverty, into relative affluence. This process is likely continue for the foreseeable future. Yet, there are serious dangers on the horizon.
The path that the United States has pursued in its trade relations, in which it opens up its market for manufactured goods partly in exchange for greater protection of intellectual property in developing countries, is likely to prove harmful on both sides. There is also the risk that obsessions with budget deficits in the United States and elsewhere could lead to a prolonged period of stagnation. And, we may not have seen the end of bubble-driven growth.
The best defense against the risks is a free-flowing debate in which other countries freely challenge the perceived wisdom coming out of Washington. The United States badly misled the world with many of the economic policies it promoted in the last three decades. We will all be best served by a vigorous debate over the best paths forward and not to have other countries moving in lockstep behind the United States.