A Decade to Lose
03-04 11:26 Caijing
If governments don't understand and simply try to bring back the "good times" of an asset-based economy, it could result in a decade of stagnation.
Lastly and the most obvious, the negative wealth effect from the evaporation of US$ 50 trillion paper wealth is cutting into consumption. The rule of thumb suggests that the negative wealth effect is about 5 percent. As two thirds of the global economy is consumption, ceteris paribus, the global economy can contract by 3 percent just due to this effect. Its impact is not all felt yet. Most consumers will adjust slowly.
The inventory cycle and reduced capex are temporary factors pulling down the global economy. At some point, inventories are sold, and capex is too low to cut. I suspect that inventory destocking will be completed in the first quarter of 2009, and that capex stabilizes in the third quarter. The global economy will probably show stability then. As fiscal stimulus kicks in around the word, we may see a significant bounce in the global economy in the second half of 2009. But stability or a stimulus-inspired bounce won’t lead to a sustainable recovery. Consumption weakness will haunt the global economy for a long time. The over-leveraged western consumer needs to pay down debt for years to come. Rising unemployment will make the problem worse. The western consumer – the driving force behind the global economy for the past decade – is down and out for good.
Governments must understand the lasting nature of the current downturn. The bursting of the credit bubble triggered the fall. The mismatch between income and demand could delay a sustainable recovery for years. During the bubble era income distribution became more and more skewered towards asset-based activities. For example, the profit share of financial activities among U.S.-listed companies quadrupled. Similar trends happened in many countries. The income for the workers in finance increased in a similar fashion. The bulging income from the financial sector was quite concentrated among a small group that spent money in luxuries and financial investment. This is the most important factor for rising concentration of income distribution around the world in the past decade.
The bursting of the bubble will destroy most income in financial activities. The amount lost could be one tenth of GDP. From limo drivers to luxury homebuilders, the compounding effect from the financial meltdown will leave unemployment across many industries and countries. The recovery becomes sustainable only when supply side is restructured to cater to a different demand mix. This process could take a long time to complete. But governments might prolong the downturn by making the wrong decisions. For example, governments around the world are engaging in fiscal stimulus. To some extent they are choosing winners, but if the ventures they back are way off what market would support, the stimulus would delay recovery. Stimulus is necessary in a severe downturn like now. It just needs to match the structural changes to come.
Let us think
through the problem facing an unemployed banker and his ex-driver. The banker
could splurge and hire a driver since he was making 20 times his driver’s wage.
Of course, in addition, he was paying for his florist, tailor, maid, masseur,
etc. On average, he spent 70 percent of his income on the equivalent of 15
people like his driver full time serving him and put 30 percent back in
financial investment like in a hedge fund. Now, the ex-banker moves to
The banker’s income before came from asset market activities, essentially redistributing income to himself by manipulating asset prices. As he stops doing that, the cost for economic activities goes down by the amount equal to his income. But the people serving him have lost their income. The net result is that the economy contracts by the same amount as the banker’s income plus 15 unemployed people. In addition, the 15 unemployed people can’t spend. The multiplier effect magnifies the banker’s income contraction, possibly by a factor of two. The world looks worse off with a smaller economy and more unemployed.
When the government steps in to stimulate, it is essentially borrowing the equivalent of banker’s ex-income to spend. The purpose is to keep the 15 people employed. However, the government won’t spend on drivers, nannies or florists. The mismatch means the government can’t get the economy back with stimulus. It shouldn’t. The driver must find new customers. The banker is gone for good. What the government should try to do is stop the multiplier effect from the 15 people that the banker no longer hires. If these 15 people get unemployment, it could go a long way to mitigate the multiplier effect. The economy can come back when it is restructured so that the 15 people find new employment.
The world will
eventually be better off. The banker was just redistributing income to himself.
The money would lead to more productivity if it could be directed to more
productive people. It’s just that the process of adjustment could be long. The
world has experienced an asset-based economy for two decades. It has led to
extreme income distribution. In the last few years, large manufacturing
companies like GE and GM came to depend on financial activities for profits.
Their industrial activities were really used as a fund raising platform. In
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