Satyajit Das Presents a Global Economy Health Check
Mr. Global Economy gets a metaphorical physical and psychological examination. Here are the results.
Mr. Economy's physicians originally hoped that the BRIC (Brazil, Russia, India, and China) nations would offset weakness in more developed and weaker elements. Unfortunately, China's growth is slowing rapidly. India and Brazil have also lost momentum, with growth weakening. Russia is dependent on high energy prices.
BRIC weakness is a function of lower demand from developed countries reducing exports and weaker commodity prices.
The withdrawal of European banks, which are historically major lenders to emerging markets, has decreased the flow of money to countries needing foreign investment. For example, in 2011, large European banks accounted for 36% of global trade finance, based on a World Bank study. 40% of trade credit to Latin America and Asia was provided by French and Spanish banks. As the European banks, besieged by financial problems at home, reduce their international activities, the supply of financing has decreased and its cost has increased.
Emerging markets also show increased susceptibility to the developed world credit virus. A rapid expansion of domestic credit in China, Brazil, Eastern Europe, Turkey, and India will result in banking system problems. The combination of external and internal weaknesses threatens emerging economies, which are naturally prone to serial crises.
As requested, our psychiatrist has assessed the psychological condition of Mr. Global Economy.
He concluded that Mr. Economy is delusional, believing complete recovery is imminent. Presented with contrary evidence, he quoted philosopher Friedrich Nietzsche: "There are no facts, only interpretations."
Like many terminally ill patients, Mr. Economy has embraced faith-healing techniques. Keynesian and monetarist regimes, he believes, will boost demand and create sufficient inflation to bring his elevated debt levels under control.
The Keynesian cure entails government spending financed by taxation or borrowing to restore Mr. Economy's health. There is no evidence that it can arrest long-term declines in growth.
Government spending boosts activity temporarily, but may create excess capacity in the absence of underlying demand. Nostalgia about President Roosevelt's infrastructure projects during the Great Depression is misplaced. Excess electricity generation capacity from dam projects was only absorbed by wartime demand for defense equipment.
As tax revenues have fallen due to slower economic activity, governments have already borrowed to finance large budget deficits.
The government's ability to borrow to finance further spending is increasingly limited, without resorting to the innovative monetary techniques. In recent years, the US Federal Reserve has purchased around 60%-70% of all US government debt issued. The European Central Bank is now financing governments indirectly by lending to banks to purchase sovereign bonds.
The ability of the US to finance its large budget deficit relies heavily on several unique factors. The US Federal Reserve and the banking system flush with central bank funds have been a large purchaser of US government bonds. The status of the US dollar as the major trade and reserve currency has allowed the US to find buyers of its securities, even at very low interest rates.
The limits of the government's ability to borrow and spend are highlighted by the European debt crisis. Investors are increasingly concerned about public finances, and becoming reluctant to finance nations with high levels of debt or demanding high interest rates.
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