New era of caution and prudence?

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The Straits Times (Singapore)
October 17, 2008 Friday
New era of caution and prudence?
BYLINE: Linda Lim, For The Straits Times

AS GLOBAL credit markets unfreeze with the help of more and more government involvement in bank recapitalisation, extended loan guarantees and the like, what lies ahead for the United States and world economy?

The recession in the US will be deeper, and recovery slower, than anticipated just a month ago. Heavily indebted households and a depressed housing sector laden with excess capacity will retard the recovery of consumer spending.

Past US recessions were usually short- lived and shallow because consumer spending was almost always maintained. Weak consumer spending will mean a harder climb out of high unemployment and a slower revival of business investment.

The US government, laden with accumulated and new debt obligations, is unlikely to provide more than short-term fiscal stimulus next year. Whoever is elected the next president will have to shelve most of his spending and tax cut proposals. The evidence of the post-Reagan years has unequivocally shown that far from 'paying for themselves' by stimulating growth, tax cuts result in massive budget deficits. These must eventually be paid for by reduced consumption (higher savings), particularly if the deficits were spent on current consumption, rather than on longer-term productivity- enhancing investments in education, health, infrastructure and research and development.

Significantly, neither presidential candidate has talked about the severe benefit cuts and tax increases that would be required to save Social Security and Medicare for the large number of people from the baby-boom generation about to retire. This factor, together with the heightened risk aversion and increased regulatory costs arising from the financial crisis, will exert a drag on future US economic growth. Capital is likely to become more costly for businesses, and returns more constrained, though there is likely to be some relief from lower commodity prices in response to slower growth.

Globalisation could help mitigate the US downturn. But recession or slow growth in other major markets means exports cannot immediately take up much of the slack in domestic demand, though underlying dollar weakness should return once the current panic-driven flight to the safety of US treasuries recedes. In the longer term, emerging market growth, particularly in China, should recover strongly.

Foreign capital inflow - particularly direct investment attracted by depressed asset values - could help alleviate capital constraints, while stabilising the dollar, rescuing bankrupt companies and creating employment. The American distaste for inward foreign investments is likely to recede with the crisis.

But the problem of international macroeconomic imbalances still needs to be resolved. As the US current account deficit shrinks, so must the surpluses of other countries. Japan, China and other economies that have managed their currencies to maintain large export surpluses will have to rebalance their domestic economies. In Japan's case, this will partly happen naturally, over time, as its ageing population draws down its savings.

Chinese officials already recognise the social, political and economic logic of increasing domestic consumption which, at only 40 per cent of GDP, is lower than in nearly all other economies. This will require continued appreciation of China's currency, as well as reform of its financial sector, so that domestic savings can be more efficiently transformed into productive domestic investments. Unfortunately, slowing growth at home, and recession in the US and Europe, will make currency appreciation and reduced dependence on exports more painful than it otherwise would have been.

In this context, it is unfortunate that the implosion of Western financial systems, hitherto upheld as aspirational models, has reduced their credibility. The motivation and political will to continue with market-oriented reforms to free up low-return savings for more productive use in societies like China's is likely to be dampened.

New multilateral policy coordination mechanisms are likely to emerge. Already, pre-crisis, the emerging academic consensus was that free capital flows across borders may on balance not be good, especially for small economies. Now it is likely that governments around the world will become more cautious about opening up their capital accounts, at least to short-term flows.

It has been suggested that 'finance will become more local' since it is easier to assess and manage risk locally than globally. Even in the US, most small local banks did not over-extend themselves with risky mortgages, unlike the more 'sophisticated' regional, national and global banks.

What about international trade, which has played a distinctly understated role in the US presidential campaign? Recent polls show that only a bare majority of Americans supports globalisation - a sharp decline from just a few years ago, and much lower than the proportions in other developed countries. The main concerns of free-trade opponents are not with trade per se, but rather job loss, income stagnation and increasing inequality in the US. These are inaccurately attributed to trade liberalisation, import competition and outsourcing rather than to technological and business process changes, and regressive fiscal policies.

The income stagnation or decline experienced by over 90 per cent of American workers over the past eight years has been blamed for not just rising protectionism but also for the current financial crisis. As income increases eluded them, Americans sought to maintain and increase their standard of living through debt. This was partly financed by foreign creditors, and partly by domestic financial institutions that offered innovative financial instruments that purportedly diversified risk, and thus, for a time, lowered the cost of borrowing.

It is not entirely a bad thing that this era has ended.

The writer, a Singaporean, is professor of strategy at the Ross School of Business, University of Michigan.

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