Note: Hi everyone! This April and May I’ll be busy with travel, marketing, and, most importantly, fundraising activities for Art and Finance, so no new Finance Blog posts (after this one) until June. But we will continue Ilusion through April and May and finally finish our super-long Chapter 5! Otherwise, see you in June, where we will be publishing some really good stuff! Anyway, here’s our writeup on the global economy:
As the goal of our website, Art and Finance, is to make Business and Finance understandable to non-Finance people (and sell a lifestyle while doing so), we believe now would be an opportune time to go over the basics of the global economy, how it functions, and what challenges it is currently facing. Hopefully, you will get a better understanding of the bigger picture when you vote.
Of course, we can’t cover the global economy in its entirety in a single blog post. Consider this a starting point that provides key concepts you can refer to once you’re reading other opinions and analyses. Furthermore, we may go over some of the concepts introduced here in closer detail in future posts.
Part 1: The Global Economy – Key Concepts
Background: International Trade
When understanding the global economy, it is important to understand the concept of international trade. Why would countries trade? At the heart of the pro-trade argument is the theory of comparative advantage. If country A can produce products A and B, but can produce product A at a lower cost compared to other countries, it has a comparative advantage in product A, which it can export to country B, which has a comparative advantage in producing product B. The social benefit of trading is that consumers get a wider choice of products to consume, at lower prices.
In reality, has trade benefited people? Studies point to the success of trade in recent decades, particularly with the case of the East Asian economies. Trade has had an important role in the global alleviation of poverty and higher standard of living.
There are negative aspects related to international trade, however. The clearest aspect is the dismantling of domestic industries and therefore potential permanent loss of jobs and standard of living for workers. For example, workers that produce product B in country A may lose their jobs and not get another of a similar quality. Other concerns include poor labor standards in other countries and environmental degradation.
Note that these negative aspects are related to trade, but are not necessarily due to trade. Trade negotiations could provide for laws regarding labor and the environment, for example. Regarding the loss of domestic jobs, it may be the domestic government’s task to enact policies that help these workers.
Background: Understanding Currencies
All countries use money to facilitate the exchange of goods and services. Although in the domestic market we differentiate between currency (notes and coins) and deposits, foreign currency refers to all types of money (currency and deposits) of another country.
An exchange rate is the price at which one currency is exchanged for another. Exchange rates are important in the global economy because when people from country A buy things from country B (known as country A’s imports or country B’s exports) – in other words, when countries A and B trade – country A (buyer) uses country B’s (seller) currency.
These transactions are done over the foreign exchange market. Also, while trade is one use of foreign exchange, there are other uses for foreign exchange, such as when people travel to foreign countries.
Currencies are subject to the supply and demand laws we’ve previously discussed. One major factor that influences supply and demand for currencies is supply and demand for a country’s exports.
Because of this, one implication of foreign exchange is that countries that want to export more may want their currency weaker relative to those of importing countries.
Background – Balance of Payments: Combining Trade and Currencies
Here we tie trade and currency together. All countries record their international trading, borrowing, and lending (both private and public) in their balance of payments accounts, of which there are three:
- The current account, which records trade. The current account balance is exports less imports, plus net income, minus net transfers.
- The capital account, which records foreign investment in the domestic economy, less investments abroad.
- The official settlements account, which records changes in government reserves, which are the government’s holdings in foreign currency.
Importantly, the sum of all three accounts must equal zero. Often, the implication is that for countries that import more than they export, meaning that they are in a trade deficit and their current account is negative, they must pay for it by increasing their capital account and/or their official settlements accounts. That may mean, on the capital account side, selling debt to foreign countries (since for foreign countries, buying debt is a form of investment in a country), and, on the official settlements account side, selling foreign currency reserves (remember that imports have to be paid in the selling country’s currency, so by selling foreign currency and thereby strengthening the domestic currency, paying for imports becomes easier). If the country uses debt to finance its trade deficit, it is a debtor country. For creditor countries, the case is the opposite of the above: exports exceed imports, the country buys more foreign debt than issues its own, and its foreign currency reserves may increase.
Given these sorts of transactions, currency plays a key role in trade and the balance of payments. For example, if country A’s currency is stronger than currency B’s, that means it can import more of country B’s product. As such, central banks must have a policy toward exchange rates. There are three possible exchange rates:
- Flexible exchange rate (also known as floating or fluctuating exchange rate): The exchange rate is influenced by supply and demand.
- Fixed exchange rate: The exchange rate is pegged to a specific value. To maintain this value, governments would have to intervene in the foreign exchange market, buying and selling their currencies to influence supply and demand.
- Crawling peg: The government intervenes in the foreign exchange market so that its currency follows a target path.
It is important to note that flexible exchange rates are indirectly influenced by central bank policy. Recall in our post on monetary policy, when the central bank cuts interest rates, the supply of money increases, and vice versa. This influences the exchange rate because of supply and demand: more local currency means weaker local currency (can buy less foreign currency, and foreign currency buys more local currency), and less local currency means stronger local currency (can buy more foreign currency, and foreign currency buys less local currency).
Part 2: Some Historical Context
Background – The Bretton Woods System for the Global Economy
The current issues the global economy is facing have their genesis in policy decisions made in the 1970’s that transformed the pre-existing regime under which the global economy operated, the Bretton Woods system. To get an understanding of what happened, let’s look first at what the Bretton Woods system was.
The Bretton Woods agreement in 1945, concluded by the United Nations following the end of World War II, established a fixed exchanged rate regime based on the US dollar as the world’s reserve currency (given the US’ dominant economic position and the fact that it had 75% of the world’s monetary gold), and all other currencies pegged to the US dollar, with the US dollar being linked to gold.
The motivation for fixing exchange rates this way was because, in the preceding decades, world financial markets had been chaotic. The idea behind the Bretton Woods system was stability; countries trading with each other would eventually settle in gold, eliminating lasting trade imbalances (ie, lasting current account surpluses and deficits). After all, theoretically, the value of gold was fixed to $35/ounce, so countries that imported more than exported, for example, could exchange gold as a payment for imports, rather than issuing debt or selling foreign currency, as we described above. In the case where a country would not be able to pay for its trade deficit, the International Monetary Fund, or IMF, also created at Bretton Woods, would be the lender of last resort.
Also, an important precept of Bretton Woods was that capital flows were restricted to avoid speculation against currency pegs. We’ll see why this was important later in the post.
Because it provided US dollar-funding and liquidity to other countries’ central banks, the US effectively became the central bank of the world, financing global economic development. International trade also increased during this period, meaning that current accounts were liberalized. It seemed like a golden age, with over two decades of rapid economic expansion. So what happened?
There are several factors why the Bretton Woods system was abandoned (some opinions on which you can read more about here, here, here, and here), but one major factor was that, as the world economy grew, the demand for the US dollar grew as well, and eventually gold reserves were not enough to back the US dollar, as gold is a finite resource. In 1971, the fixed exchange rate system disintegrated, although the US dollar remained the world’s unit of account and source of liquidity. From this period onward, the world has been operating on a flexible exchange rate regime.
The 1980’s – Capital Account Liberalization
During the Bretton Woods era, current account liberalization took precedence over capital account liberalization. Countries used capital controls in place to limit the flow of money to and from their capital accounts. One reason capital accounts were not liberalized at the time was due to the fixed exchange rate regime, which would have been difficult to support if capital flows were uncontrolled. If things were going so good, why did everything change and capital accounts were liberalized?
In the late 1970’s, the world was gripped in oil-price shocks, pushing up prices in a potential example of cost-push inflation. Conventional economic theory at the time was that higher inflation would be associated with lower unemployment and higher economic growth. This was not the case in this period, when inflation was high, unemployment was high, and monetary policy was expansionary (ie, larger supply of money). Monetary policy thus shifted toward restricting the money supply. It was successful, and even today a focus on the money supply and its relation to inflation is a cornerstone of modern monetary policy.
Stagnant economic growth and inflation, and the ensuing successful monetary policy response, paved the way for private sector-oriented reforms in the global economy, meaning less government intervention in markets. There are different accounts as to why this happened. Regardless, the shift began in the 1980’s, and one such reform was the liberalization of capital accounts, meaning that capital controls were lifted.
We mentioned debt as one item in a country’s capital account, but it is not the only one. Capital flows to a capital account include portfolio investments (including debt and equity investing), bank borrowing, and foreign direct investment (FDI). In particular, it is important to distinguish between portfolio flows and FDI, as we will see later.
Foreign Portfolio Investment (FPI) involves investments in financial assets of a country. This can include, but is not limited to, buying the debt another country issues.
Foreign Direct Investment (FDI) can involve buying a stake in a foreign company large enough to assume control. It can also mean developing an entirely new project abroad – for example, building a factory. FDI does not mean merely investing in large projects abroad. It often involves the transfer of skills, management, and technology.
Both types of investments are important to a foreign country’s development. FPI, however, tends to be more volatile than FDI, since investors in financial assets can theoretically sell their foreign holdings at the sign of trouble.
And while FDI has proven to help economies grow, as seen with the development of East Asian economies, one controversial consequence has been the rise of outsourcing – essentially, the movement of jobs overseas. After all, once technologies and skills are transferred to a foreign country, that foreign company learns the necessary skills to provide a comparable service, initially at a lower price.
These shortcomings of capital account liberalization have led some to criticize such processes.
On the other hand, there have been benefits from capital account liberalization. Because capital controls have been lifted, it’s much easier now for us to travel, with positive implications for countries’ tourism industries. And it’s easier for you to buy Japan-listed shares of Nintendo. And products are much cheaper now. Moreover, competition and lower product prices may have potentially led to technological advancement, improving our standard of living. FDI and outsourcing can also work in the reverse; for example, recently, China has been increasing FDI into the US for advanced manufacturing.
Productivity: The Rise of Emerging Economies
The mid- to late-twentieth century saw the rise of East Asian “Tiger” economies, whose rapid development involved an infrastructure-led strategy, first pioneered by Japan. With strong infrastructure, they were able to take advantage of both trade and capital flows to grow their economies and increase their standard of living, given competitive manufacturing industries.
Manufacturing can be seen an “escalator industry” that help rapidly develop an economy. This is because of the concept of productivity. A country has high productivity when its GDP grows faster than capital and labor. When countries start manufacturing – in other words, when they industrialize – from a low base, with wages lower relative to other countries, GDP grows fast and tends to increase the standard of living and alleviate poverty.
In recent decades, China, with its 1.3 billion citizens, has followed this strategy. Industrialization has helped the economy grow and lifted many out of poverty. China’s rapid industrialization and growth took place in the context of both current and capital account liberalization, with the country taking advantage of FDI and cost competitiveness in trade.
China’s industrialization sent major ripple effects throughout the world, affecting both developed and emerging economies.
Related to China’s rapid industrialization was the rapid outsourcing of manufacturing jobs in developed countries such as the US, as China became cost-competitive in manufacturing. On the other hand, some developed countries that specialize in advanced manufacturing, such as Germany, have benefited from exporting higher-end products to China.
Another ripple effect for non-East Asian emerging economies, from Brazil to Indonesia, was China’s massive demand of raw materials, helping these economies grow.
Part 3: Today – Secular Stagnation?
Secular Stagnation and Capital Account Liberalization
Now that we’ve gone over the key concepts and events preceding the current state of the global economy, let’s review the current issues the global economy is facing. See the following chart:
For the sake of simplicity, we use the theory of secular stagnation to tie all these seemingly disparate global issues together. Secular stagnation is an influential theory that posits that high savings, low investment and increased risk aversion combine to hamper stronger inflation and economic growth. Global trends that support the secular stagnation argument include:
- Aging global society: Longer-term trends indicate a decreasing global labor force, as populations in developed economies and even emerging economies age. Potentially, this could improve global living standards, as fewer young workers do more work, increasing productivity and wages. On the other hand, some believe an aging global society means problems for the global economy, as less investment is needed. Also, emerging markets may face problems, given potentially less demand for products and therefore less of a chance for industrialization.
- Capital account liberalization that motivates investment abroad: FDI abroad naturally means less investment by domestic investors in their own economy.
- Technological advances: As technology improves, it becomes more efficient, requiring less investment. Technological advancement may also be linked to trade and outsourcing, as materials become cheaper and make development of new products viable.
- Corporate management may not reward investing.
Such trends result in weaker corporate investment, meaning that businesses are spending less on tangible assets such as equipment. Instead of tangible assets, these excess savings may then end up fueling financial asset bubbles. Two potential examples of this is the Global Financial Crisis (GFC) in 2007-09 and current emerging market crisis.
Though the theory of secular stagnation has critics, it’s a useful concept to tie in what we will be discussing going forward. Let’s go over these issues one-by-one.
How Capital Flows Influenced the Global Financial Crisis
Some thirty years after the end of Bretton Woods and the free market-oriented reforms that followed, the world experienced the GFC.
There were many reasons for the GFC, but the main point that pertains to the global economy was FPI flowing into the US.
Between 2000 and 2005, the US’ current account deficit grew rapidly. In order to balance payments, its trading partners, which had current account surpluses, accumulated the US dollar via purchases of US debt (known as Treasuries). Foreign ownership more than doubled from $1 trillion in 2002 to $2.1 trillion in 2006. This helped bring down US interest rates (demand for Treasuries brings up the price of Treasuries, which means that interest earned on buying Treasuries decreases), magnifying an already-low interest rate regime in the US and contributing to the economic bubble that popped in 2007.
While developed economies were reeling from the GFC, emerging economies seemed to weather the storm quite well, but not for long…
The Monetary Policy Response to the Global Financial Crisis
Following the GFC, the US Federal Reserve (the US’ central bank, or “Fed”) began purchasing long-term bonds and mortgage-backed securities in a program known as quantitative easing, or “QE”. This was done to spur the US economy. How would it do so?
Recall that in standard monetary policy, the central bank influences interest rates indirectly, by changing the amounts of deposits, or reserves, that banks keep in it. In 2008, legislation allowed the Fed to pay banks an interest rate on excess reserves, incentivizing banks to keep these reserves with the Fed. The Fed then used these reserves to purchase interest-rate bearing securities to bring down interest rates. It works like this:
Since the Fed more directly lowered interest rates, including long-term interest rates, both the stock market and housing market recovered, as sentiment improved with a pro-business environment underpinned by these rates.
The idea behind QE was this: low interest rates bring up asset prices, which in turn would encourage companies to raise money and invest, make households feel wealthier and spend more, and reduce bankruptcies and foreclosure, spurring a recovery in bank lending.
Sensing the QE worked at least enough to prevent total catastrophe, the Fed engaged in three more programs of QE, while other central banks, including those of Japan, the EU, and the UK, engaged in QE programs of their own.
The results have been mixed. While QE did prevent an all-out collapse of the global economy, economic growth has been lackluster compared to the pre-GFC world.
Despite seemingly halting global catastrophe, QE has also faced criticism against further implementation. Central to the argument against any more QE are 1) the fact that low interest rates may lead to unexpected high inflation, 2) moral hazard, and 3) the potential creation of future asset bubbles that will once more lead to a global economic crisis. Let’s go over these three major arguments.
QE may lead to unexpected high inflation due to expansionary policy leading to demand-pull inflation, as wages rise. Normally, this is desirable, as mainstream monetary policy involves inflation targeting. This means that the Fed enacts monetary policy to attain a certain inflation rate for the purposes of price stability. Remember that expected inflation can be in line with a well-functioning economy. The risk, then, is price instability, where inflation and therefore prices rises too quickly, depressing the economy. Furthermore, if the central bank is forced to rapidly raise interest rates to combat high inflation, it may also halt economic growth. In reality, however, inflation has been constrained, and in some cases, deflation has become a possibility.
(On a related issue, given such risks and lackluster results so far, some have begun to question whether inflation targeting is even useful anymore.)
Moral hazard also presents another risk from QE. One clear example is the banking sector, which has benefitted from rising financial asset prices due to low interest rates, despite being a key player in the GFC. Rich households, which hold considerable amounts of financial assets, have also benefitted from this environment. Moreover, banks and companies have hoarded the cash that was printed to spur investment. In more extreme cases, banks and corporations that would have gone out of business in a normal interest rate regime continue to live on, despite their low investments in the real economy.
QE also risks generating an asset bubble. QE is one cause of increased real estate prices in various economies and has potentially created a bubble in the tech sector. The bubble that economists and journalists have recently focused on, however, is in emerging markets (“EMs”).
Emerging Markets: The Next Big Asset Bubble?
As we have seen, a low interest rate environment increases loans and credit in general. With a large amount of credit in the in the US market, yields (the monetary gain from a debt’s interest rate and repayment for its given price) are low, so money managers, such as pension funds, mutual funds, and, importantly, hedge funds that borrow money, search for higher yields abroad, engaging in FPI.
Since these capital flows involve buying EM currency to invest in EM assets, EM central banks have to deal with their currencies appreciating, a negative for exports. So central banks start buying developed market (“DMs”) assets, but, since these central banks are taking these assets onto their balance sheets, they must issue liabilities to fund these purchases. They do so by printing money, which makes its way to the local banking system and economy, which in turn further increase the supply of money since banks have deposits with the central bank. Thus, an asset bubble is created.
Previously, EMs had generally been benefitting from economic policies from China. Following turmoil in DMs in the wake of the GFC and thus loss of export revenue, China shifted its economic policy to a massive infrastructure boom, fueling demand for global commodities, which EMs exported. The commodities boom in turn helped EM economies, letting them take advantage of incoming capital flows by borrowing and importing, without addressing more fundamental issues holding back long-term economic development.
This follows a borrowing binge in EMs, where the EM private sector took advantage of a weak US dollar following the GFC by issuing US-dollar debt. Corporate debt in EMs is now over $18 trillion, with as much as $2 trillion in local currencies. Given the current strengthening of the US dollar following the Fed’s hike on interest rates, which we discuss below, EM corporations may have a more difficult time paying off dollar-denominated debt.
Recently, China has once again changed economic policy, now shifting from infrastructure-led economic growth to consumption-led growth. Recall that as an economy grows, so does its wage rate. As a result, China can no longer compete in exports and must rely on its own citizens to buy its products and support its economy.
Because of China’s economic rebalancing, the decrease in infrastructure- and export-led growth has hit its economy, slowing economic growth, in turn affecting EM corporations that benefitted from Chinese demand for raw materials. In 2015, EM debt defaults reached their highest levels since 2004. The risk is that this wave of private sector defaults may spill over into the public sector.
Moreover, weakening economies potentially expose political and social weaknesses in EM, potentially leading to instability.
Recall that countries that want to export more may want to have their currencies cheaper than other currencies.
Some argue that another motive for QE was to weaken domestic currencies, due to low interest rates and thus a larger supply of money. This would make exports more competitive, spurring some to charge countries with engaging in a “currency war”, with competing devaluations of local currencies.
Another major potential reason for weakening currencies is interest rate divergence. Seeing signs of an improving US economy, the Fed hiked interest rates on December 2015. Since higher US interest rates leads to a stronger US dollar, the news of a rate hike caused an outflow of capital from EMs, depreciating EM currencies. It is also another cause for EM defaults, as EM corporations find it harder to service US-dollar debts as the dollar strengthens.
Interest Rate Divergence
Interest rate divergence poses a challenge to the global economy. While the Fed recently hiked US rates given the US’ improving economy, other economies have continued to keep rates low. In fact, several economies, including the EU and Japan, have cut interest rates so low they are now negative, by charging banks that hold reserves in the central bank and hopefully incentivizing savers to spend. So far, results have been mixed, with most banks being reluctant to pass these costs onto depositors.
The net effect of the US hiking rates while other major economies are bringing them negative would be a reinforced strengthening of the US dollar and weakening of other currencies, as investors search for higher yields. This may exacerbate the problem of US dollar-denominated debt we talked about earlier.
In addition to the acute financial crises we’ve described above, recent trends in the global economy that have arisen over several years that bear mentioning.
The first is that global trade has been weakening since the GFC. In recent years, trade growth has slowed to be in line or even lower than global GDP, whereas it previously grew at twice the rate of global GDP growth. The risk with lower trade is that the world will be trapped in a low-growth environment.
One recent cause for weak trade is weak demand from EMs, given the issues we previously discussed. There are, however, deeper causes. One may be a shift in consumption habits that favor resource-light devices (think about software-driven smartphones versus automobiles). Another is China’s shift from an investment- to consumer-driven economy. Lastly, aging demographics in DMs mean less demand for global products – a major risk for EMs.
Despite all this, trade continues to be important for many economies, given the currency devaluations we’ve discussed. And a much larger complicating factor are the political and social repercussions of trade.
A Trade Backlash?
Despite trade’s role in increasing global prosperity following the end of World War II, the loss of local industries and jobs have understandably led to a social and political backlash in DMs such as the US. If anti-trade leaders are elected in these countries, the protectionist policies could potentially cause a trade war, which may spiral out of control into an actual war. Such considerations have led to criticisms that economic models that support trade do not take into account the difficulty of economies to transition once trade increases. On the other hand, some attribute much of the loss of DM jobs to China’s rapid development, a one-off event given its size and speed of industrialization.
In our view, what might be the solution for countries losing out due to current and capital account liberalization, such as the US, might be to develop a strategy to make the country as a whole more competitive in the global economy. Indeed, some have cited the upgrade of US infrastructure as a near-term source for employment. Better infrastructure could in turn provide the US with a base on which to execute a strategy, in our view. We’ll talk more about this in a future blog post.
Conclusion: We are Global Citizens
If the thesis of a global economy where nations face similar and interrelated economic problems, like that of secular stagnation, holds true, then perhaps a response on a global level is needed, in addition to policies related to domestic issues. In fact, some are indeed suggesting global-level policies. IMF Managing Director Christine Lagarde, for example, wants global investment to favor FDI over FPI, given the recent crises. Others propose that individuals and institutions view savings and investment flows as global, not national. Ideally, money from strong balance sheets, whether public, quasi-public, or private, would flow worldwide to productive investments. The role of global institutions are thus important and must be understood by citizens.
Dealing with problems within economies may involve some combination of productive investments (for example, in infrastructure and human capital), backed by proper monetary policy (admittedly debatable given the controversy of QE, but at least we should have this discussion) and even fiscal policy, which might have to be explained carefully to the public if it involves tax hikes. In our view, this could be more easily facilitated if we properly take advantage of global capital flows to bolster such policies. Other initiatives proposed include global debt reduction, given that at this point in the cycle, debt reduces demand. Still others go further and advise that we rethink the basic structure of debt contracts to allow for flexibility. Regarding an EM-specific issue, a move toward the implementation of the impartial rule of law is essential. These are all ideas worth considering, and these are conversations that we, as global citizens, should have; it should not be relegated to politicians and bureaucrats. Hopefully, this blog post gives you an idea of the state of the global economy and how it functions, and can help you make decisions when you vote.
Ramon Rodrigo Cuenca, CFA
Art and Finance
CFA Program Curriculum Level I, 2009, volume 2, p. 483
CFA Program Curriculum Level II, 2010, volume 1, pp. 527, 529, 552-3, 562, 569, 572, 575-577