Is the World Drifting Toward a New Financial Crisis?

After nearly seven years from the end of the deepest global financial crisis of the postwar period, growth continues to be slow and uneven in advanced countries and falling in most emerging markets. There is even the risk that the world may be drifting toward a new global financial crisis.

In this paper, I will examine the dramatic economic events and the crucial financial challenges that the world faces at this juncture. These are:

1. the slow and uneven economic growth in the advanced countries after the recent global financial crisis,

2. the recent dramatic slowdown in the rate of growth in emerging markets (especially in China) and recession in others (such as Brazil),

3. the danger that the world may now be drifting toward a new global financial crisis,

4. the suspicion that there may be some underlying and more fundamental negative forces at work in the world economy today that may make slower world growth the “new normal” and, even more ominously,

5.  that the world may actually be facing secular stagnation.

Economic Growth is Slow and Uneven in Advanced Countries

Since the end of the 2008-2009 recession, the U.S. growth rate averaged 2.2 percent per year and is forecasted to be 2.6 percent in 2015 and 2.8 percent in 2016. While Europe and Japan would probably be satisfied with these growth rates,  the United States is not. The reason is that the recovery was not rapid enough to bring the United States back on  its long-run growth trend line following the recent deep recession. It is true that the U.S. rate of unemployment declined from the high of 9.6 percent in 2010 to 5 percent in 2015, but in the meantime more than five million discouraged workers (4.1 percent of the labor force) have dropped out of the labor force and so are no longer counted as unemployed. Furthermore, median family income is about $3,000 lower today than in 2007.  

Europe fared worse than the United States. Euro Area growth averaged only 0.7 percent from 2010-2014 (the Euro Area even fell back into recession in 2012-2013) and growth  is forecasted to be only about 1.5 percent in 2015-2016. The situation was even worse in Japan (which was in recession in 2011 and 2014) and growth is now forecasted to be less than 1 percent for this year and the next. Britain and Canada fared better, with growth rates since the end crisis approaching those of the United States.

The United States and other advanced nations responded to the “Great Recession” by rescuing banks and other financial institutions from bankruptcy, slashing interest rates, introducing huge economic stimulus packages, making very large injections of liquidity, and also undertaking heavy nontraditional expansionary monetary policy (quantitative easing or QE). These efforts, however, only succeeded in preventing the recession from being deeper than otherwise and from making the subsequent recovery even slower than it was. Be that as it may, growth remains the most serious economic problem facing most advanced nations today.

Some experts advocate additional (new) big stimulus packages to speed up growth in advanced countries, but these may not succeed to the extent that today’s slow growth is due more to the slowdown in productivity and in the rate of innovations than to inadequate aggregate demand. But we will return to this topic later.

Growth Slowdown in China and Recession in Brazil 

The economic crisis in emerging economies started as a result of contagion as the recession-afflicted advanced market nations sharply cut imports from and the flow of investments to emerging markets. This was one reason for the decline in China’s previous spectacular growth. India’s growth rate also declined, while most other large emerging economies (Russia, Turkey, Mexico, and Brazil) face recession.

But the reduction in China’s growth rate is even more the result of its effort to restructure its economy toward more internal demand and a service economy rather than relying on continued export growth and on heavy domestic investments, as in the past (the former because it is no longer sustainable and the latter because of the setting in of the dreaded diminishing returns). In the process, China’s demand for primary commodity imports from other emerging markets (especially Brazil and Africa) declined sharply. This caused an even greater growth slowdown in emerging economies than the decline resulting from the recession in advanced countries.

As the demand for their primary exports declined, the currencies of emerging market economies sharply depreciated or were devalued, thus making the servicing of their previously accumulated heavy financial debt and dollar borrowings unsustainable. Emerging market economies are now experiencing large net financial outflows, which exacerbate their economic problems even more. Thus, Brazil, which a year ago was expected to have slow growth, is now in a deep recession, with a decline of its real GDP expected to be as high as 3% this year.

Some emerging market economies are now in need of quick and substantial financial assistance in the form of loans from the IMF and other forms of financial assistance in order to avoid even deeper financial and economic problems. Financial assistance is also needed to help them restructure their economies away from excessive reliance on exports of primary commodities and toward their service and manufacturing sectors (as China is doing), so that more of their future growth would be generated endogenously. But, as China is finding out, this is not easy to do, because it can lead to a further slowdown in growth during the restructuring process, as the costs are incurred up-front while the benefits only come gradually over time.   

Is the World Drifting Toward a New Financial Crisis?

We have had global (or nearly global) financial crises in 1987, 1992, 1997, 2001, and 2008. Before almost all of these crises, advanced nations adopted powerful (and often excessive) expansionary monetary and fiscal policies that temporarily stimulated faster growth by financial excesses that created a bubble, the bursting of which then triggered a crisis and recession. This is the case for the dot-com bubble that led to the 2001 crisis and the subprime mortgages bubble in the U.S. housing sector that triggered the recent crisis. These crises quickly spread from the United States to other advanced nations because of even greater financial excesses in some of these other nations. 

Sometimes, we hear (even some experts) say “too bad, the economy was growing reasonably well, but then the crisis came,” not recognizing that some of the previous growth was actually the result of financial excesses (i.e., purchased by the economy being on steroids). Thus, in measuring the nation’s average growth rate over a period of time it is important to also factor in (include) the recession year(s). This leads to the question “is the world drifting toward a new global financial crisis?”

A new financial bubble may, in fact, be in the making. With official interest rates near zero and real rates negative (as they are now), investors, in search for returns, are likely  to undertake “excessively” risky investments. This generates a new bubble, the bursting of which can trigger a new crisis.

Continuing to use expansionary monetary and fiscal policies when growth is slow, not because of a cyclical reason (i.e., inadequate demand) but rather because of structural problems (such as the slowdown of innovations and productivity), are self defeating because they may lead to financial excesses (bubbles), and eventually to a financial and economic crisis. Nations should adopt appropriate regulations and avoid pursuing “artificial” growth by financial excesses.

Regulations, however, cannot prevent all crises because the next crisis will most likely be different from the recent crisis or previous ones. The question is not whether or not we will face a new financial crisis, but rather when it will come. There will always be crises.

What appropriate regulations can do is trying to avoid some crises and reduce the severity of others. This can be accomplished by putting in place appropriate procedures, measures, and reforms (such as the Euro Area’s Banking Union being created and avoiding having banks "too big to fail"). In the present situation, it is also important to remember that most of our economic and financial weapons and ammunitions have already been used to fight the recent crisis, and so they not be available to fight the next crisis when it comes.

But there is a totally different view that the greatest danger facing the world today is not simply another financial crisis, but rather, and more ominously, stagnation for the foreseeable future, which could only be averted by huge fiscal stimulus. We will examine the merit of this position next.

Is Slower Growth the New Normal?

The above is a crucial and fundamental question. Let me reword and extend it before attempting to answer it, as follows. Are there longer-run forces at work in the world economy today (besides the shorter-run cyclical forces related to the recent global financial crisis and great recession) that are causing a general and protracted slowdown of growth in both advanced and emerging market economies? Is this one of the reasons for the severity of the recent recession and for the anemic recovery, and for the persistence of slow growth six years after the crisis — despite the adoption of powerful expansionary monetary and fiscal policies during the past years. More broadly, is this what is preventing the world from going back to its pre-crisis growth levels? Is slower world growth the inevitable “new normal?”

Financial investors and those working in Wealth Management who provide better answers to the above crucial questions and who more clearly understand the challenges facing the world economy today will surely be more successful than others in managing their financial affairs and business now and in the future.

There is some evidence that the growth of advanced countries is slowing down because of the slowdown in productivity growth. More ominous would be if this slowdown in productivity will continue for the foreseeable future — as some growth experts believe. According to them, the most dramatic and spectacular inventions (the combustible engine, electricity, the PC, the Internet, etc.) have already occurred and so new inventions are not likely to lead to as high productivity growth as in the past. If true, this can also explain, at least in part, the severity of the recent crisis and the slow recovery and growth that followed. It also spells major troubles for the future growth of the world economy because innovations are the main drivers of productivity, and hence of world economic growth in general. Other growth experts disagree with such gloomy predictions.

Independently of who is more nearly correct, it is crucially important to encourage innovations. Thus, in 2014 the European Union introduced “Europe 2020” with aim of making Europe the best place to innovate and to invest, and hence encourage economic growth. Innovations can be encouraged by education, the commercial applications of basic research, investment subsidies, and so on. But is difficult to anticipate how successful these policies will be.

It is easier to identify the fundamental reasons for possibly slower growth of emerging market economies in the future. These are:

1.  the rapid slowdown in population growth and in the growth of the labor force,

2.  the convergence hypothesis (i.e., it easier to grow when starting from a very low base (when there are many technologies still available to be copied or adapted than later on),

3.  related to the convergence hypothesis is the so-called “middle-income trap” (i.e., the difficulty of emerging market economies taking off to reach advanced-economy status), and

4.  in today’s highly interdependent world, a slowdown of growth in advanced countries would inevitably lead to a slowdown in the growth of emerging economies (and vice-versa).

Is the World Facing Secular Stagnation?

There is a significant minority of economists and experts who believe that the most serious problem facing the world economy today is not the risk of another global financial crisis but, more ominously, the danger of secular stagnation in advanced nations and growth recession in emerging markets — and that these could be prevented only by a huge and coordinated fiscal stimulus on a global scale.

The evidence that these economists and experts provide for their views is that growth is slowing down dramatically all over the world. In advanced countries because of the slowdown in technological advances and inventions, and in emerging market economies because of both the slowdown in advanced countries and as a result of dramatic reduction in China’s growth. China’s rapid growth slowdown leads to deep cuts in its imports of primary commodities from other emerging markets as well as in other imports from advanced countries. This slows the growth of emerging and advanced economies alike, which in turn can lead to a domino effect of downward spiraling growth for the entire world economy — at least so the argument goes.

All this would be happening despite huge traditional and non-traditional (QE) expansionary monetary policies in all of the leading advanced and emerging market economies since the time of the recent crisis. With low or negative current and expected inflation and real interest rates in most advanced economies, it is clear that monetary policy would be powerless to prevent the downward spiral of growth and stagnation if they came to pass. The only way to avert secular stagnation, according to the pessimists’ view, is by a coordinated, massive injection of public expenditures (fiscal stimulus) on the global scale directed at building and repairing infrastructures. These are supposed to increase productivity and growth, and pay for themselves.

Is this diagnosis of the problem correct and the policy solution advocated likely to be effective? That the world may be facing secular stagnation is possible, but by no means certain. For example, the strong prediction of stagnation in the United States right after World War II turned out to be completely wrong! But even without secular stagnation, isn’t the world heading toward another global financial crisis that a massive fiscal stimulus could help prevent? But have most nations not done just that during and after the recent great recession, and yet rapid growth did not ensue?

Those predicting secular stagnation and advocating massive public expenditure to prevent it are quick to respond that the fiscal stimulus provided by most countries during and after the recent crisis were not large enough to do the job, and that it was directed primarily to welfare expenditures rather than to infrastructure investments. In any event, bigger, much bigger, fiscal stimuli are advocated. But the U.S. public debt rose from 64 percent of GDP in 2007 to over 100 percent today. How high must the United States and other nations be prepared to push their public debt to fight possible stagnation? And what would happen if the massive public works undertaken were not to lead to increases in general (national) productivity to justify them? Hasn’t Japan’s tried this for past two decades to no avail (its debt is now 246 percent of GDP)? Will markets continue to finance these huge larger debts at reasonable rates indefinitely?

The answer given by those who push for the above plan of action is “we face stagnation  now and the plan of action that we advocate is the best way to deal with it.”

After nearly seven years from the end of the deepest global financial crisis of the postwar period, growth continues to be slow and uneven in advanced countries and falling in most emerging markets. The dangers facing global economy today are greater than at any time since collapse of Lehman Brothers in September 2008. There is even the risk that the world may be drifting toward a new global financial crisis in the background also of possible secular stagnation. There are conflicting opinions as to how the world could best respond to these dangers.

 

Prof. Dominick Salvatore

Distinguished Professor of Economics, Director, Ph.D. Program in Economics Fordham University (New York), Honorary President of Megatrend University (Belgrade) and Honorary Professor at Shanghai Finance University, Hunan University, University of Pretoria, and LUM (Free University of the Mediterranean). Honorary President of Megatrend University (Belgrade) and Honorary Professor at Shanghai Finance University, Hunan University, University of Pretoria, and LUM (Free University of the Mediterranean). Consultant to the Economic Policy Institute (EPI), World Bank, International Monetary Fund, United Nations.