While there is no doubt that the current recession is fundamentally linked to excesses in financial markets and asset prices, there were still some classic macroeconomic imbalances that preceded the crisis. For years we have been talking about global imbalances and how certain advanced economies (the US in particular) were building large deficits. A current account deficit is simply a measure of the difference between spending and income for a country. The source of spending can be many (government, companies – in the form of investment- or consumers). In the case of the US, consumption grew to levels that we had never seen before. The chart below displays household consumption as a ratio to GDP for the US and four other advanced economies.
This is a ratio that we expect to be fairly constant for a country with stable growth rates (as it is the case for these economies). In fact, in the cases of Germany, France and Japan, consumption remains fairly stable during the sample, as we expect. It is true that in the case of Japan we see the ratio increasing in the 70s but this has an explanation: as convergence in living standards materializes, the country’s saving rate goes down from the very high rates of previous decades; rates that were needed to sustain the very high growth rates of Japan in the 50s and 60s.
The US, and to a much smaller extent the UK, have seen consumption increasing at rates much faster than GDP for the last two decades. In the case of the US the ratio reached a peak of almost 72% in 2007. How could this trend be justified? For this number to go up, a combination of these things should happen:
While one can always debate about whether some of these assumptions were reasonable during the last decades, overall one finds more arguments that go in the opposite direction and might have justified a lower consumption rate. An aging population and a growing government debt make the future look worse than the present. If any, there is the need to increase saving (i.e. reduce consumption). In terms of productivity growth while the 90s looked good, there is no consistent signal that productivity growth is accelerating dramatically in the US or UK economies.
How can it be that in the light of such strong evidence of a macroeconomic imbalance very little was done about it? During those years asset and housing prices were booming and this was used as a justification for the consumption increase: as a ratio to wealth (not income or GDP), consumption was not growing that fast. Of course, for this to be true those asset prices had to be sustainable and this could only happen if one of the arguments above was true (for housing prices to remain as strong as they were before the current crisis one had to assume very high future demand for houses because of large income or population increases).
Today’s perspective is, of course, very different as asset prices have collapsed and consumption looks also very high relative to wealth; it is clear that these imbalances need to be addressed. Unfortunately, this is the wrong time to address such an imbalance. In the middle of a deep recession, economic policies work to stimulate consumption, not depress it. If consumers starts saving now they will make the recession even worse and this will reduce income and wealth even further, a recipe to make the adjustment even more difficult. No surprise that policy makers, such as Larry Summers today in an interview with the FT, are making the arguments that this is not the time to save. Point taken but let’s make sure that when we are out of the recession we look back at this chart and make a conscious decision to avoid these growing imbalances reappear again in the future.
Antonio Fatás
It looks as if today will be another difficult day for financial markets as AIG just announced the biggest loss in history ($61.7 billion for the last quarter of 2008). As markets in Asia and Europe opened with significant loses, the US dollar has climbed against all other major currencies. At $1.26 per Euro is back to the level it reached in November and December 2008 when financial markets were close to collapse.
What this crisis has shown us is that the US dollar remains the currency of choice for investors when panic reaches financial markets. Over the last months we have witnessed an interesting negative correlation between the daily performance of the US stock market and the dollar. In days where the stock market does poorly, the dollar tends to gain relative to other currencies, a sign that there is a flow towards US dollars when uncertainty increases and bad news spread.
The recent appreciation of the dollar stands in contrast to what we had seen in the run up to the current recession. The US dollar had depreciated heavily relative to the Euro and reached a minimum of about $1.6 to the Euro. The depreciation of the US dollar was seen as the way for the US to rebalance the deficit in the current account as imports became expensive and US goods improved their competitiveness.
It is interesting that after the crisis becomes evident in the Spring of 2008 and when the US current account deficit has not improved that much, the US dollar starts reversing course and appreciating. Also, this trend has been very much ignored by policy makers on both sides of the Atlantic. From the perspective of the US, the appreciation of the dollar at the time that the US government is engaging in a massive fiscal stimulus cannot help. Increased spending in the US will only help the US economy if it translates into purchases of US goods. If all the increase demand goes abroad, the rest of the world will be very happy but the fiscal stimulus will have limited effect on the US GDP.
Of course, one can argue that the current depreciation of the US dollar is bringing it back to “fundamental” levels (closer to what purchasing power parity tells us), but I am not sure the capital flows that are moving the exchange rate are motivated by these arguments.
How long will the US dollar remain the currency of choice in times of uncertainty? How long will foreigners be willing to hold US assets that pay a very low interest rate? There is no doubt that the future evolution of the US economy relative to other countries will be a key factor to answer these questions. Until then, and as we are seeing today, confidence and a long history of being the world reserve currency will determine capital flows and the value of the US currency in difficult and uncertain times.
Antonio Fatás
There is also a claim that Roosevelt’s term was associated with the highest unemployment rate and therefore his policies were unsuccessful. The high unemployment rate was a legacy of the Great Depression. During his first term, however, unemployment declined from 25.2% in 1933 to 14.3% in 1937.
Ilian Mihov
