Kemal Derviş heads the United Nations Development Programme, the UNDP. On 12 June he gave a keynote address to the Institute for International Finance-Ditchley Conference in Italy. It is striking for its bold sweep and, in these turbulent times, for presenting an integrated picture that assesses the impact of the credit crunch within a global framework that includes technical innovation and the impact of the developing economies. To briefly summarise his important argument, Derviş is optimistic in the medium to long run for five major reasons:
- Technology and relative peace put us in a historical period of high potential for material growth
- Catch-up growth, especially in Asia, will lift millions out of poverty; because of emerging Asia and other Middle Income Countries' high national savings and investment rates, the global investment rate is rising.
- Keynesian demand management has avoided the worst of the depressive phases of our "bi-polar" economy
- Scarcity is pushing commodity prices up, but we can continue to improve material well-being even with carbon properly costed
- Stable and sustainable world growth requires huge material transfers around the world--from oil producers to post-industrial debtors; from energy reducing to energy intensifying economies that require legitimate and properly functioning international institutions.
Tony Curzon-Price, Editor-in-Chief
- After 1 year of economic turmoil ...
- Growth Acceleration
- Decoupling of the emerging markets
- Financial sector storms
- Commodity Prices
- National and global policy responses
With the high summer season upon us, we were surely hoping that the very tumultuous 12 month period might be giving way to somewhat greater calm. Some of us might have been looking forward to a short holiday some time soon. Things started to look more promising towards the end of May when the IMF declared that it would revise upwards its growth projections both for the world, the US and the Eurozone. But then came the bad news at the end of the first week of June: bad employment figures in the US and the barrel of oil gaining 16.24 dollars in less than 36 hours reaching 139.12 dollars a barrel, a record high, a week ago. The "delta" in less than two days was equal to the entire price of a barrel not so long ago, in itself an amazing fact. Clearly the summer will not be an easy one.
Also in openDemocracy on the fallout of the
2007 financial crisis:
Tony Curzon Price, Responsible Recessions
Avinash Persaud, The dollar standard: (only the) beginning of the end
Ann Pettifor, "Debtonation: how globalisation dies" (15 August 2007)
Christopher Harvie, "Gordon Brown vs Scotland: the balance-sheet" (17 September 2007)
Tony Curzon Price, "Gordon Brown: between rock and hard place" (18 September 2007)
Tony Curzon Price, The end of gentlemanly capitalism
That is not all. There are other big problems, ahead of us. Thinking back to June of last year, the world economy was then projected to grow at an impressive 3.4 percent rate (in real terms and converting to US dollars at 2005 market exchange rates) in both 2007 and 2008, based on a survey of forecasts undertaken on June 11th. In April 2007, the IMF estimated that the world economy would grow at 3.4 percent in 2007 and 3.5 percent in 2008 (2000 constant prices and market exchange rate). GDP growth projections (correcting for price levels) were 4.9 percent for both 2007 and 2008. The consensus forecast for the US economy for 2008 was close to 3 percent. The price of oil was around 70 dollars a barrel--very high in nominal dollar terms but still far from historical highs in real terms.
While concerns over oil supplies and increases in commodity prices were surfacing, global inflationary expectations were subdued: the consensus forecast for global inflation in consumer prices was of 2.5 percent in both 2007 and 2008. Asset prices were generally strong across a wide range of asset classes and in many countries in spite of the decrease in housing prices, especially in the US, which had peaked nationally in late 2006 and risk premia were at low levels. Despite Martin Wolf of the Financial Times, among others, but particularly Martin Wolf, writing that financial markets had been carried away and that a serious adjustment was unavoidable, many were still betting on even higher asset prices and financial returns.
Things started to unravel in the summer of 2007. In fact, it was almost exactly one year ago, in mid June , that it became known that two large mortgage hedge funds managed by Bear Sterns that had large exposure to subprime mortgage backed securities had suffered very large losses in a matter of weeks, as delinquencies on subprime mortgage loans increased. Spreads on structured products linked to US home equity loans and especially subprime mortgages increased sharply from mid-June onwards, largely as a response to the reports of losses by the two Bear Sterns funds. Bear Sterns had to make substantial injections of capital to enable funds to meet margin calls. By the time the funds were liquidated, at the end of July, the troubles had spread to Europe. Short term debt secured with collateral that included US subprime mortgages created problems at IKB, a German bank that required an injection of funds from its main shareholder, KfW.
And in early August BNP Paribas froze redemptions in three of its funds, blaming the complete evaporation of liquidity for its inability to price securities backed by US assets, which included subprime mortgages. It was then that the interbank market seized up, with banks hoarding liquidity and refusing to lend to each other, triggering strong injections of liquidity by central banks in the US, Japan, Canada and Europe. Until the end of the year, central banks sought to respond to reduce the liquidity concerns, culminating with a coordinated action of the US Fed and European central banks on 12 December 2007. In the first months of 2008, concerns moved beyond interbank liquidity to asset quality and credit availability. The US Fed took the unprecedented step of extending credit to broker-dealers, and worked with JP Morgan to avoid the bankruptcy of Bear Sterns in March of 2008.
By April 2008, the IMF's global growth projection for 2008 was revised downwards to 2.6 percent for both 2008 and 2009 (2000 constant prices and market exchange rates). In fact growth projections had been revised downwards several times by the major international institutions throughout the period from June 2007 to April 2008.
In a somewhat strange "decoupling," the price of oil had reached $112, a new historic high in real terms in April, and increased further to $125 in May. In addition, commodity prices over a very broad range were also reaching historical highs, not something that usually happens with weak growth and prospects for a recession.
So, early this year the strong shadow of a four headed monster ahead of us became well entrenched:
- a slow unravelling of the sub-prime mortgage disaster continuing to undermine the financial sector and constraining credit in parts of Europe and the US;
- a recession in the US (many economists, perhaps a majority, were predicting it) coupled with a significant slowdown in the world economy;
- oil prices racing possibly towards a previously unthinkable 150 dollars a barrel or more; and
- a huge increase in food prices translating into a massive set-back in the fight against poverty as hundreds of millions of urban poor and landless rural poor were facing the prospect of losing well over one third of their real income. Just think about a family already barely surviving and spending about 60 percent of their income on food, facing close to a one hundred percent increase in the price of the food they have to buy.
A financial sector crisis, a growth slowdown, an energy crisis, and a food price crisis, all in one. This is really a perfect storm right after 4 years of exceptionally good world economic progress that seemed to benefit from sunny blue skies! Just about when the last optimists were ready to throw in the towel a few weeks ago, the situation did however appear to stabilize. The first quarter growth numbers in the US came in much better than expected. The first release by the US Department of Commerce in late April estimated 0.6 percent annualized growth in the first quarter, ahead of the consensus forecast of 0.2 percent growth for the year. This first estimate was revised upward to 0.9 percent in late May, meeting the consensus forecast at the time of the release of the data, which had improved markedly since early in the year. Similarly, first quarter growth in the Eurozone came in at 0.7 percent, higher than the 0.5 percent that had been forecasted by the European Commission prior to the release of the data. Emerging market growth is on the whole steaming ahead with not much sign of a slowdown: for China it was 10.6 percent year-on-year ( against first quarter of 2007 that was 11.7 percent y-o-y); India's economy expanded 8.8 percent in the first three months to March 31 from a year earlier. So for the first time in a year growth projections are being revised upwards rather than downwards! It seems that the only thing that has been consistent throughout the last 12 months is that the consensus forecasts have been consistently wrong, with revisions always downwards, except, thankfully, the last weeks.
So allow me to take a somewhat longer term economist's perspective in my remarks today, and try to see the broad patterns emerging in the global economy. When it comes to the distinction between the long-run and the short run, I always remember a lunch I had with a friend who was at the time a bond trader at the World Bank. We were arguing about the dollar-Deutsche mark exchange rate. I was arguing that the Mark would go up in the long run, while he was arguing with equal passion that, while I might be right in the short Ðrun, in the long run it would fall. At the end of the lunch, after failing to reach agreement, we finally found out that what he meant by the long run was about a month whereas I was thinking in terms of three to five years, and that my short run was about a year compared to his short run off about a week. So I am going to abandon the short run now and focus on the long run as I understand it, and I will focus on five central points.
First, it is possible to say that there is an underlying growth acceleration in the global economy discernible over the last two decades compared to secular trends and experience. Global trend growth is largely determined by four factors:
- the pace of progress in the technological "frontier", which essentially takes place in the advanced economies;
- the pace at which technical know-how spreads throughout the world;
- the global investment rate; and
- Institutional stability and the absence of major violence and destruction.
The information revolution has lead to a rapid developments in technology that increase productivity. Total factor productivity growth in the US from 1960 to 1995 was 0.56 percent. Total factor productivity growth jumped to 0.85 percent from 1995 to 2000 (with information technology contributing 0.51 percentage points); and again to 1.03 percent from 2000 to 2005 (with information technology contributing 0.33 percentage points). The liberalization of trade, the collapse of the Iron Curtain, the massive increase of FDI as well as the much easier access to knowledge via the internet have all led to this technical know-how spreading much faster. The very high savings and investment rates in Asia in particular have combined with this spread of know-how to generate very impressive "catch-up" growth. Developing Asia saves almost 45 percent of its GDP and invests close to 40 percent of its income! Finally the world has been spared the kind of massive destruction it had to go through twice in the 20th century, although we are not by any means at world at peace. Since the turn in the century the steadily increasing weight of developing Asia means that unless there is a prolonged real recession in the advanced economies, or some kind of cataclysmic conflict, the average trend growth rate of the world economy will continue to accelerate.
Decoupling of the emerging markets
Second, and as part of this story, thanks to catch-up growth, the trend growth of some of the major emerging market economies has indeed decoupled from that in the advanced North. It is now much higher and will stay higher. This is not to say that there is decoupling in the fluctuations around the trend. But high savings rates and the ability to rapidly absorb new technology thanks to relatively stable institutions facilitating both, will mean the continuation of much higher growth rates in many Southern economies. This also means a fundamental structural change in the composition of world growth.
A steadily increasing share of growth comes and will continue to come from the South and this is indeed the biggest single reason for the acceleration in the aggregate growth rate. The mainly Asian " southern acceleration" was already well on its way in the 1980s and 1990s, but it could not at the time have a determining effect on the world aggregate because the weight of the Asian South was not yet big enough. It was also counterbalanced in the 1990s by a particularly sharp Japanese slowdown. But by the turn of the century the emerging South's weight had become large enough to lead to a visible acceleration in world growth.
Financial sector storms
Third, the trend growth has been periodically affected by financial sector storms in which asset price bubbles have played an important role. The Asian crisis in 1997, the dotcom bubble burst in 2001, and the sub-prime mortgage problem constituted shocks to the world economy that led to a temporary slow-down in growth. In the 1997 and 2001 episodes, the initial predictions were for much more pronounced slowdowns. It is too early to say whether the same will turn out to be true for the 2007 financial crisis, but it wouldn't surprise me if the upturn became sharper than predicted. Nonetheless, it seems clear that the major short-term economic threat to rapid and sustained world economic growth comes from what one could call "manic-depressive" cycles in the financial sector, with the manic phase very dominant in the last ten years, encouraged as it has been by monetary policies, particularly in the US. A regulatory framework that catches up with the complexity and innovation in the sector and that explicitly adopts a countercyclical objective would help protect the world economy from these shocks and add hundreds of billions of real income otherwise lost in admittedly so far short downturns.
I have a personal experience to share on this point. In the spring of 2001, having just taken the responsibility of economic affairs in Turkey after the terrible financial crash of February 2001, I visited the US Treasury to ask support for an ambitious adjustment programme and large supportive financing form the Bretton-Woods institutions.
Then Treasury Secretary Paul O'Neil received me politely but with marked lack of enthusiasm for backing IMF funding. He asked me why we didnÕt simply sell whatever assets the public sector owned instead of borrowing more money from the IMF. He pointed out that the public sector owned a lot of real assets in Turkey at the time. I answered that I was favourable to privatization in principle, because it could raise productivity and help get partisan short-term politics out of economic and commercial decision making, but that selling assets with a "mark-to-market" approach at the trough of a crisis at bargain-basement prices was not actually going to improve the long-term public sector balance sheet. Turkey was facing a debt crisis and we did not want the liquidity problem we faced to turn into a public sector solvency problem.
He did not convince me, I did not convince him, but with backing of some top economists in the Bretton-Woods institutions and others, (thank you Bill Rhodes, thank you Bill McDonough, thank you Josef Ackermann), we convinced the IMF Board to provide the financing that allowed Turkey to manage the crisis, restore equilibrium in the public sector accounts and embark on a period of very rapid growth. If we had not had the financing and instead had to sell our assets at "crisis" prices, I am not at all sure that we could have achieved such positive results, even if it had been politically possible.
Of course comparing countries to individual institutions may not always be valid, but my personal experience makes me cautious as to the validity of insisting on "mark-to-market" pricing in crisis situations. So I am all for a regulatory framework that helps prevent a crisis and reduces systemic moral hazard. In fact what we need to do much better is to manage the "manic" phase of the cycle. But when "depression" strikes we cannot allow it to take hold and simply allow our desire for punishing the guilty to deepen the pain and suffering throughout the world economy. So far at each recent financial crisis including the current one, public policy has intervened to help restore confidence and has helped the world economy regain momentum. Keynes would be proud while Milton Friedman would be very unhappy. It is clear that Keynesian discretionary macro-economic policy is what is practiced Ð without much of Chicago school type constraints on government macro-economic activism.
There are risks, of course, in the timing and magnitude of policy moves, and there may be those who will argue that if only the Fed had allowed the dotcom bubble to burst with much greater pain we would not have had the sub-prime bubble. There is no doubt that the risks have now shifted with inflation becoming a very serious world-wide concern. But given where the US and the world economy had arrived at in the second half of 2007, I believe the Fed made the right moves.This is not to say that macroeconomic policy was always correct. Somewhat higher interest rates and much tighter fiscal policy in 2005 and 2006 in the US would have been necessary and desirable. Such a stance would have allowed an earlier reduction of the US current account deficit and moderated the exuberance of financial markets.
Macroeconomic policy by itself cannot, however, fix financial sector problems. If we want to improve the performance of the Financial Sector, what is needed are regulatory reforms aiming at less pro-cyclical behaviour. Adjusting Basel II risk-weighted capital requirements upwards with the growth of credit would be onereform that could be very helpful and reasonably easy to implement. The key is to actually manage and moderate the up-swing Ð the "manic" phase Ð which is what causes the biggest problems later on.
While financial sector problems lead to regrettable output losses and temporary interruptions, they will not in the longer run and in the absence of huge and unlikely policy mistakes, alter the underlying world economic growth acceleration, driven by technology, globalization and an increasing global investment rate financed by unprecedented savings rates in emerging Asia and also the oil rich countries. Close to one half of humanity today invests close to 40 percent of its income and uses that investment to adopt and adapt technology and production methods on the whole readily available, generating huge productivity increases and catch-up growth. Moreover there remain ample not fully utilized labour resources that can be further trained, provided with the capital created by unprecedented investment rates and drawn into the global production process.
This saving and investment, more than anything else, is driving the world economy today and it will not be substantially affected by the financial sector problems of the first world economies. It will, however, as I said before, rapidly alter the geographic structure of world income creation.
So does that mean that the world economy can propel forward at a 4 to 5 percent aggregate growth (at purchasing power parity prices) rate compared to the 2 to 3 percent achieved in the 20th century, without any long-term worries and constraints?
In trying to answer this question let me now share my perspective on the huge increase in commodity prices--oil as well as food.
First, some words on the role of financial investors and speculation in commodity markets. I have little doubt that both financial investors and speculative behaviour explain part of the massive increases in commodity prices that we have seen across the board. The data show that there has been a huge inflow of financial capital into commodity markets, much of it not to finance additional capacity in commodity production, and some of it betting on further increases with the aim of a rapid exit when the time comes. One particularly notable recent development is related to the large financial flows that are being channelled by investors that traditionally focused on equity and debt securities. These are usually index speculators linked to hedge funds and money managers that track commodity price indices. Index investors take exclusively long positions and are "price insensitive" Ð at least until there is a clear trend reversal of price collapse Ð rolling-over their positions to ensure that their portfolios have a targeted exposure to commodities indices. According to one estimate, index investment has increased from $13 billion at the end of 2003 to $260 billion by March of 2008 in US commodity futures markets alone.
In the case of oil, estimates of the marginal cost of producing and delivering crude oil has gone up since the late 1990s, but now range from 60 to 85 dollars a barrel Ð a multiple of the 10 dollar a barrel price of a few years ago and in line with the price of about a year ago, but much lower than the current price of oil. An important issue here relates to inventories. Substantial speculative demand should translate into increases in stock levels which we do not actually see for most commodities, with the possible exceptions of metals.
Each commodity has to be looked at carefully, however, when analyzing inventories. For oil, which as a liquid is hard to store above ground, speculation can simply lead to more of the product being kept underground, compared to what would otherwise be the case. For agricultural products this cannot be done, and one should see actual increases in stocks. Here too, however, one must remember that a sizable part of world stocks can be kept by small producers and are not easily measured. Low interest rates as well as the collapse in the profitability of some other investment vehicles have contributed to some hoarding and speculative demand.
But when we look at the big picture, the speculative and excessive component of recent price increases is not the most important part of the story. It is there and has, no doubt, prepared the ground for a retreat of many commodity prices from their record highs in the next 6 to 12 months, but it should not mask a deep structural change reflecting the pressure of demand caused by the growth acceleration on some of the world's natural and environmental resources. Many of these resources are available in inelastic supply: they can only be increased at substantial cost.
This contrasts with the elastic supply of manufactured products and many services. It is important to realize that the supply of manufactures has become more elastic over time, as technological monopolies have been more difficult to keep, as huge new labour supplies have been incorporated into the modern global economy and as capital has become more abundant. The result is likely to be a change in relative prices favouring most, if not necessarily all, commodities and environmental resources, particularly those limited by real natural resource constraints.
I would like to stress in this context the impact of bio-fuels. The role of biofuels should not be seen as a separate factor in the overall increase of the relative price of natural and environmental resource constrained products. Estimates for the portion of real, exchange rate adjusted food prices rises due to bio-fuel production world-wide range, broadly, from about 10 percent to as high as 70 percent. There is little doubt that biofuel production is affecting food prices with causality working through multiple channels.
Between 20 and 50 percent of feedstocks, such as corn and rapeseed, are being diverted to biofuels. The price of corn is most directly affected, but, as corn is an input in the production of meat and dairy products, and a close substitute in consumption of soybean oil, corn price increases trigger price increases in these products. Moreover, land diverted to the production of corn reduces the land available for the production of wheat. One can probably say very conservatively that at least one third of exchange-rate adjusted food price increases have been due to resource diversion to biofuels. This resource diversion itself was triggered by the energy, carbon emissions and global warming problem, and in that sense reflects the overall natural and environmental resource constraints faced by the world economy.
But bio-fuel production also reflects, in the case of corn-based ethanol subsidies, very misguided policies, even from a purely environmental perspective, since the environmental benefits of those kinds of bio-fuels seem to be close to zero. Let me add here, that both China and India are actually small net food exporters and in direct and net terms have not been significant contributors to food price inflation. It is indirectly, through the energy channel, that one can say they have had an important role.
I am willing to take the risk and predict that there will be a decline in real commodity prices at some point over the next 12 months, including in the price of oil, as there are aspects of a bubble and a bit of "froth" in current prices. There will be a supply response with wide variations across commodities, and there will be unwinding of speculative positions. Demand cut-backs in the case of oil are also likely and, according to the IEA, already taking place in the developed world while not present in parts of Asia, and the Middle East in large part due to subsidies that cushion the pass-through of international to domestic prices.
But this does not mean even coming close to the low relative commodity prices seen in the late 1990s. The higher prices that have developed over the last few years reflect the increasingly binding natural and environmental resource constraints faced by the world economy as GDP growth tries to maintain its Asia-driven acceleration. It is the need to protect the atmosphere from rapidly rising stocks of greenhouse gases, the limited availability of fresh water supplies in many parts of the world, as well as the limited supplies of traditional primary energy at historic prices, and not financial sector problems, that constitute the real long-term constraint on the rapidly growing world economy. Oil close to 150 dollars per barrel is a signal that we must act.
These constraints can probably be overcome for many decades, and maybe centuries to come, if relative prices adjust, if carbon can be priced to reflect its true cost for the world economy and if technology can be unleashed to find the substitutes and solutions that no doubt exist. For example, lignocellulosics - second generation feedstocks that will not compete with food for land- could be developed for large scale production of bio-fuels. Carbon-capture technologies could help produce energy from still large coal reserves without the massive CO2 emissions currently involved in coal based power production. Perhaps a safe and acceptable way to expand nuclear energy will be found. All this will require a new set of relative prices, however, and generally involve higher prices for energy and many commodities compared to the last 50 years.
Carbon, in particular will have to be priced accordingly Éprobably closer to 200 dollars and later 300 dollars per ton rather than the 40 dollars per ton currently available in the existing limited carbon markets.
National and global policy responses
Let me conclude that while such adjustments are quite possible and would allow the continuation of the wonderfully rapid growth that the world economy is capable of, with the potential of lifting hundreds of millions of people out of miserable poverty, it will require pro- active management at both the national and international levels of the very difficult and large distribution and equity problems that are involved.
Relative prices changes have effects not only on resource allocation and incentives, but also on the distribution of income and economic power. If we want the world economy to adjust smoothly to both the new geographic structure of growth and the new emerging constraints of the 21st century, we have to face the distributional and political problems that the adjustments imply and have to mitigate the adjustment costs.
Some of the mitigation will necessitate cross border resource flows on a scale that we are not accustomed to. Whether it is sovereign wealth funds of oil rich nations investing large amounts in the advanced post-industrial countries, or large resource transfers implicit in a global cap-and-trade scheme to energy hungry India from Western and Japanese corporations, these cross-border flows will have to grow to magnitudes not yet imagined.
To make this possible will require not just well functioning global markets, but also a system of international political cooperation and functioning international law that will have to replace past dreams of unilateral hegemony, lack of cooperation and the current turbulence and inefficiency in global issues management.
I hope that in the long-run, an economist's long run, we can make real progress in international institutional reform. This should not be seen as an esoteric topic of interest mainly to bureaucrats. Even without touching today on the security and political threats the world faces, the economic threats alone require cooperative action.
The global economy offers immense promise and opportunity. But it must be managed as a global system with much greater emphasis on environmental sustainability and a better reflection of its new geographical structure. Nobody should think that they can go it alone. It is time for real multilateralism and decisive reforms in the methods of international cooperation.
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