\input 0.sty   
{\obeylines
From article@mises.org Mon May  2 22:31:13 2005
Date: Fri, 29 Apr 2005 09:45:02 -0400
From: Mises Daily Article $<$article@mises.org$>$
To: Mises Daily Article $<$article@mises.biglist.com$>$
Subject: The Future of the World Economy}

\parskip3mm  
\b
{\tbf The Future of the World Economy}

by Stefan Karlsson


      [Posted on Friday, April 29, 2005]

Last year, the world economy grew by 5\%[1], its fastest rate for many
years, led by the extraordinary boom in China and very high growth in
most other third world countries too. America and Japan also had fairly
strong growth, although Western Europe had a more dismal performance. Can
the good times last? Or is the world economy heading for a crisis?

The world economic boom has been driven by two factors.

In part it has been driven by a gradual liberalization of world trade and
a liberalization of major third world economies like China and India. The
average tariff level in a country like China has been lowered from 41\% in
1992 to 6\% in 2004. The increased liberalization of world trade has
increased the scope of international division of labor and permanently
helped raise growth in the world as a whole and in particular in third
world countries. Particularly if trade is freed even more, this factor
should continue to help the world economy to prosper. Another reason for
the increased growth in emerging economies is the free market reforms
implemented there with a country like China transforming itself from one
of the most destructive communist systems in the history of mankind (that
is saying a lot) to a virtual "capitalist paradise" with a seemingly
endless supply of cheap but competent labor and with no welfare state and
no unions and with many other emerging economies also undertaking free
market reforms of varying radicalism.

But there is also a darker side to the current boom. It is to a high
degree driven by the cheap-money policy of the Federal Reserve. And it is
not just the American economy which rests on this shaky foundation. Most
other economies in the world are also dependent upon the cheap money
policies of the Fed. This is partly because the rest of the world has
grown increasingly dependent upon the rising trade surplus with America
created by the excess demand in America spawned by Fed policy and partly
this is because the downward pressure on the dollar created by the low
interest rates has made other central banks emulate the cheap money
policy of the Fed in order to prevent their currencies from rising too
rapidly in value against the dollar. Moreover, world economic growth is
also dragged down by structural problems in Europe and Japan.

To better understand the prospects for the world economy, we should
analyze in more detail the strengths and weaknesses of the four main
economic powerhouses of the world: the United States, the European Union,
Japan, and China. As they are the main driving forces behind overall
movements in the world economy, it makes sense to focus on them. There
are some other fairly large emerging economies like India, Brazil, and
Russia which will also be briefly discussed.

We begin with the American economy. The American economy's strong side is
that it is still one of the most market-oriented economies in the world,
with tax rates and regulation being far less burdensome than in the major
European economies and Japan. It also has well-developed financial
markets and institutions for higher education. This is what has helped
America to remain the richest country in the world (apart from tiny
Luxembourg) and to out-perform most other rich countries. Despite the
best efforts of various American politicians to destroy these advantages,
it will likely remain a positive factor for the next few years.

The Achilles' heel of the US economy is its over-dependency on cheap
credit. Five years ago, the US experienced its largest stock price bubble
since the 1920s with valuations of technology stocks set at ludicrously
high levels. This bubble was driven by rapid money supply growth and was
accompanied by a sharp increase in the private sector debt burden and
current account deficit, both of whom reached new record levels.

The private sector financial savings rate which usually fluctuates in a
counter-cyclical way, having fluctuated between a surplus of roughly 5 \%
of GDP during recessions and around zero during booms, has now dived
sharply into negative territory at -6\% of GDP.

When the bubble burst in the spring of 2000, the US Economy seemed, given
that background, set for a sharp recession. But the 2001 recession that
followed the burst stock price bubble was very mild. The avoidance of a
severe recession was achieved by a combination of combined tax cuts and
spending increases, and the fastest and largest interest rate cuts ever
in American history, with real interest rates being pushed into negative
territory for the first time since the 1970s.

But this successful avoidance of a deep recession came at the price of
preserving and indeed aggravating the imbalances that created the 2001
recession. The end of the stock market bubble was followed by the
creation of another bubble, this time in housing. Normally during
recessions the private sector debt burden falls and household and
corporate balance sheets are restored through high net savings. But while
corporate balance sheets have been repaired as a result of a sharp
decline in business investments and record corporate profits, households
have been on an unprecedented spending spree, households are more
indebted than ever and saving even less than 5 years ago.

As a result of the budget deficit and the household spending spree, this
time contrary to the normal developments during a recession, the current
account deficit increased to new record levels, the private sector debt
burden continued to increase while the private sector financial savings
rate in a completely unprecedented way remained weaker during a recession
than it has previously ever been even during a boom. And since the
economy recovered from the recession, the build-up in debt levels have of
course continued to increase.

Thus, apart from the fact that stocks are now far less overvalued than
they were five years ago and that corporate balance sheets are now
stronger, the fundamental imbalances in the U.S. economy are in fact even
greater now than they were then. This makes the US economy vulnerable to
another economic downturn. And this time imbalances are even greater and
the means for politicians and central bankers to mitigate the crisis will
be more limited since interest rates are much lower and the budget has a
deficit instead of a surplus.  

So, when will that crisis come? Pinpointing an exact date is of course
impossible. It will be when the foundation of the current boom, that is
the super-low interest rates, is removed and/or the imbalances become so
great that they will fall under their own weight. It can also be said
that it will likely not be during the coming year. While there are some
signs that the housing boom has started to slow, this will be
counteracted by the likely continued boom in business investments.

With corporate profits at near record levels, with interest rates still
being far below their historical average and with business investments
still being below the historical average, this means that not only do
companies have the cash-flow needed to finance increased investments
without much external capital, but more importantly that the return on
investments is at a record high, so there is a strong incentive to
increase investments.

The downturn to this is that it will likely contribute to a continued
widening of the current account deficit and private sector debt levels.

So in conclusion, while we can be fairly optimistic about the US economy
in the short run because of the likely boom in business investments and
in the long run because of its still comparatively market-oriented
economic structure, the imbalances created by the Fed's cheap money
policies make a sharp recession likely in the medium-term outlook.
However, if this likely sharp recession will induce an extremely
destructive response in the form of protectionism, higher taxes and
spending, or high inflation it could make the long-term outlook more
pessimistic.

Europe has for a long time lagged behind America and most other countries
in growth. Or at least, the European Union as a whole. There are of
course great differences between different European countries. It is
mainly the big three Euro-zone countries, Germany, France, and Italy
which have had dismal growth. Britain and Spain have had much stronger
growth, while Ireland and Luxembourg have had outright exceptional
growth. But because Germany, France, and Italy stand for more than two
thirds of the Euro-zone economy while Ireland and Luxembourg are the two
tiniest Euro-zone countries, their economies are more or less synonymous
with the development in Europe as a whole.

There is of course a widespread myth that the cause of Europe's economic
problems are a too tight monetary policy by the European Central Bank.
This claim is repeatedly brought forward by both politicians in various
countries and the European business press. And Larry Kudlow even accused
the ECB of pursuing a "scorched-earth deflationary" monetary policy. Yet
this reputation of the ECB as being some kind of hard money bastion is
(unfortunately) completely false. The ECB has consistently exceeded its
own targets for money supply growth and inflation. During its 6 years of
existence, M3 has increased at an average rate of 6.7\% versus its target
growth rate of 4.5\% and the consumer price inflation has been an average
of 2.2\% versus its supposed target of below 2\%. In the end of 2004,
short-term interest rates were negative, consumer price inflation was
2.4\%, M3 growth 6.4\% and Private sector debt growth 6.9\%. The reasoning
behind ECB's false reputation as a hard money bastion seems to be the
false syllogism of "weak growth is the result of tight monetary policy.
Europe has weak growth. Therefore Europe must have a tight monetary
policy." But as the first premise is false, so is the conclusion of the
syllogism.

Instead the cause of Europe's weak growth has two, to a high extent
connected, roots.

One, its high government spending and regulatory burden which is far more
burdensome than in America and China.

And second, the rapidly aging population in Europe as a whole and
particularly in Germany and Italy. In countries like Germany, France, and
Italy, the standard age of retirement is somewhere between 55 and 60.
With the median age in Germany and Italy expected to be nearly 55 in
2050, this would imply that there would be far more old age retirees than
people in the working age population. Combined with the large number in
the working age population who live off welfare, this will imply a fiscal
collapse and a large decline in the supply of labor and capital. This
process is already taking its toll, particularly in Italy and Germany. Of
course, an aging population needn't necessarily be a problem for the
economy, provided the average retirement age rises at the same rate as
the median age. But raising the retirement age has proven to be very
difficult. When the government of France raised the retirement age for
government employees from 55 to 57.5 in the summer of 2003, it caused
large-scale protests and strikes and any politicians who try to raise the
retirement age are likely to face similar large-scale protests and
strikes and possibly be voted out of office by the welfare-state addicted
public.

But unless the European politicians take drastic measures to stop the
demographic implosion, boost employment, and raise the retirement age,
this problem will continue to get worse with time.

Germany has recently taken some timid measures to lessen its very high
regulatory burden and its high unemployment benefits, but these measures
are probably not sufficient to reinvigorate the German economy. The
outlook for the European economy is therefore pretty pessimistic. Unless
European politicians dramatically change their welfare statist policies,
Europe looks set to continue its relative decline both in the short- and
long-term perspective. And any decline in the American and Asian
economies and a continued decline in the value of the dollar, would
damage the European export industry and thereby deprive Europe of the one
source of strength it has had until now.

The one bright spot for Europe is the inclusion of the fairly free market
oriented East European economies whose tax rates are very low not only
compared to Western Europe but also compared to the United States. Not
surprisingly this has led to very fast economic growth. And as the East
European countries have become a part of the EU they will prop up overall
growth. Moreover the increased tax competition from Eastern Europe has
already started to prompt some West European countries to lower taxes,
particularly corporate income taxes, which will boost their
competitiveness. If the East European example prompts the West European
countries to radically lower taxes and cut welfare spending then the
outlook could be a lot brighter. But unfortunately that does not seem
very likely.

Japan was for a long time the rising star in the world economy, greatly
outperforming both Europe and America. But after the great stock- and
real estate bubble in Japan in the late 1980s crashed, the Japanese
economy has been stagnating with growth rates even lower than in Europe.

This has been largely because the banking system has been inhibited by
the great mass of bad loans. The Japanese authorities have been unwilling
to take on the short-term pain associated with liquidating the bad loans
and have instead gotten a prolonged stagnation. Japan also shares many of
Europe's problems.

While Japan has a much lighter tax burden than Europe, its regulatory
burden is, if anything, worse. And the inflexible economic structure
created by the high regulatory burden has made the reallocation of
resources from the inefficient companies created by the inflationary boom
more difficult than in America. For this reason the high regulatory
burden creates much more of a problem for Japan now than it did before
1990.

Japan also faces an even worse demographic problem than Europe. Already
Japan has more people aged 65 or older than people younger than 20,
something which only Italy also has. And it will get a lot worse. As
there are less than 24 million Japanese below the age of 20 while there
are 35 million in the age group 45--64, this means that the Japanese
working age population will shrink by more than 11 million or 14\% during
the next 20 years, while the total population is expected to shrink by
only a few million. As in Europe, this will create an enormous fiscal
burden and decrease the supply of both labor and capital unless the
retirement age is raised. Something which in turn will ensure a rather
dismal growth rate.

One bright spot in the Japanese economy is the rise of China. The
geographical proximity of China means that the Japanese stand to benefit
more than western economies from the increasing division of labor with
that country. Already China has surpassed America as its greatest trading
partner. Japan has however recently seen its export growth to China
sharply reduced as a result of the Chinese government's successful
efforts to restrict credit expansion. But in the long run Japan should
stand to benefit more from the rise of China than America and Europe.

Another bright spot is that Japan will also benefit from the fact that
its private sector has greatly reduced its debt burden, with corporate
debt at its lowest level in over 30 years. This means that Japanese
companies do not risk another economic bust resulting from tightening
credit conditions.

Its medium term outlook however is clouded by a possible crisis in
America and its repercussions on China and the rest of the world. And the
demographic collapse and the falling supply of labor and capital it
implies will put an increasing burden on the economy.

Since Deng Xiaoping, China has started to liberalize its economy and as a
result has experienced extraordinarily high growth. After having been
ravaged for centuries by British and Japanese imperialists, by a
devastating civil war, and by 30 years of Mao Zedong's brand of
communism, China has started to regain its former status as an economic
power house.

According to official GDP statistics converted at current exchange rates,
China's economy is still smaller than that of Britain. Yet that number
greatly underestimates China's true size as it does not take into account
that the price level is far lower in China than in Britain. In all
indirect indicators of economic size, the Chinese economy is far larger
than the British. China is, for example, the biggest consumer of coal,
steel, and many other commodities and the second biggest consumer of oil
(after America). It is also the third largest trader in the world, after
America and Germany. China is clearly already much more important for the
world economy than Britain and will become even more important in the
future.

There is every reason to believe that China will continue its
extraordinary growth rate for at least the coming decade. With no welfare
state, no labor unions and an enormous supply of both labor and savings,
"communist" China is a capitalist's paradise. And as is evident in the
success of ethnic Chinese businesses in Hong Kong, Taiwan, Singapore and
the rest of South East Asia, the Chinese have a strong entrepreneurial
spirit. And with communism no longer suppressing this, the potential for
growth is enormous.

While estimates of the number of farmers in China vary greatly depending
on whom you ask, even the lowest estimates reckon that at least half of
China's 1.3 billion people are still farmers. If the relative size of the
agricultural sector falls to western levels this means that more 600
million people will be heading for employment in the industrial and
service sectors. And 600 million is twice as many as the population of
the United States.

Combine that with the fact that China has perhaps the highest savings
rate in the world and thus will be able to make the investments necessary
to continue its high growth rate. As The Economist disapprovingly noted,
this high savings rate is to a large extent caused by the lack of a
welfare state since this forces people to save if they wish to have
enough money to for example pay medical bills.

Of course, there are potential dangers for China which could at least
temporarily derail its strong growth. The fast transition of the country
could potentially create great social unrest. The Chinese banking system
looks very fragile as it is heavily burdened by bad loans. Moreover,
China is far too dependent on exports to America. China's exports to
America last year were some 12\% of GDP and the bilateral trade surplus
was 10\% of GDP.

This makes China very vulnerable to an economic downturn in America.
First because of its direct negative effect on exports and second because
China is likely to be blamed for the crisis which could create a
protectionist backlash which will severely damage the Chinese economy. A
revaluation of the yuan would be one good way for China to reduce its
dependence on exports to America. While it would create some negative
short-term effects in the form of reduced exports and reduced value of
assets in America, it would also lower the cost of imports. And most
importantly, China would both lessen the risk of protectionist measures
as the charge of "manipulating" its currency (as if there are any
currencies today that aren't manipulated) would go away and it would also
reduce the damage caused by the protectionist measures as the higher
dollar value of the economy of China created by the revaluation would
lower the relative importance of exports to America.

Moreover, China potentially faces a conflict with America over the
secessionist "break-away province" of Taiwan.

China's outlook is very good as long as they avoid any of the previously
mentioned dangers.

This means that while the short-term outlook for the Chinese economy is
strong, it risks heavy damages from any economic crisis in America,
something which in turn poses risks for social unrest and for the fragile
banking system. If China manages to get through that crisis without the
outbreak of a civil war, the reversal of market reforms, or dramatically
increased western protectionism or a war over the issue of Taiwan, it
should thereafter be able to resume its impressive growth.

The story for some of the other major emerging economies, like Brazil,
India and Russia, have many similarities with that of China as they have
also started to liberalize their economies, something which has helped
boost their growth rates. Their potential may not be as great as that of
China because their cultures are not as inclined towards thrift and
entrepreneurship as the Chinese culture and because in the case of Brazil
and Russia their populations are much smaller and in the case of Russia
shrinking. India is also still plagued by the unofficial caste system
which makes it more difficult to spread the success to the entire
population than in China. The Russian and Brazilian economies are also to
a dangerously high extent dependent on oil and agriculture respectively.
Even so, they and many other emerging economies will likely increase in
importance.

For the world economy as a whole, we should in the short-term outlook
expect the current boom to continue but at the price of aggravating the
global economic imbalances. America's debt burden will continue to rise
while the rest of the world will grow increasingly dependent upon exports
to America. In the medium term, a strong rise in real interest rates
and/or falling confidence in America will trigger a recession there which
will spread throughout the world in the form of falling exports to
America, both because of the direct reduction in demand created by the
recession and the indirect effects of a falling dollar and possibly
outright protectionist measures. This will add to and aggravate the
domestic problems in the rest of the world.

In the longer term, we will likely see a great shift in the world economy
with China and other emerging economies increasing in importance while
Europe and Japan gradually decline in importance. Because of the problems
in the European economy, it seems unlikely that the euro will replace the
dollar as the world's reserve currency. However, in a longer term
perspective (meaning a few decades from now) the Chinese yuan might take
over that role when the yuan becomes fully convertible and when China
becomes the world's largest economy.

\bsn\hrule
\bsn
Stefan M.I. Karlsson (email) is an economist currently working in
Sweden. His speech, delivered a Mises Institute conference, is available
in audio as well. Comment on this article on the Mises Economics Blog.
See also his archive.

\bsn\hrule
\bsn
[1] If you weight the world's economies adjusted to the local cost of
living. Weighted by current exchange rates would give a too low weight to
rapidly growing but still poor countries like China and India and
accordingly lower the world growth rate.

\end