What are the characteristics of global economic crashes and how do economies adapt to them? Harold James, in his Seven Crashes: The Economic Crisis That Shapes Globalization, addresses this question that is fundamental to economic historians, investors, and policymakers. He argues that global economic crashes happened due to either supply or demand shocks; and in each crisis, major economies had to go beyond expectation to restore economic order and confidence.
James’ argument is very relevant to today’s world economy. Most parts of the world are still struggling against a looming deflationary spiral in the aftermath of the 2008 Global Financial Crisis (GFC). In fact, before the GFC, Japan had already been dealing with a deflationary crisis from the late 1980s through to the 2000s, when its economic bubble crashed. When the crisis first kicked in and plummeted asset prices in the late 1980s, Japan’s central bank was slow to respond. It was not until 2001 that the Bank of Japan finally made up its mind to tackle the deflationary crisis with an unlimited money supply. This resulted in Japan’s policy of negative interest rates that was to last for decades to come. The near-zero interest rates policy made it unprofitable to buy bonds or save money in Japanese banks. The Bank of Japan hoped that this could lead to more supply of money in the real economy.
Japan’s case set a precedent for Western economies in their approach to the 2008 GFC. In the face of shattering economic outlooks and an imminent deflationary crisis, central banks of the Western countries, headed by the Federal Reserve in the US, put in place a policy called ‘quantitative easing’, buying massive bonds from bankrupting financial institutions like Lehman Brothers. The move to bail out big banks, which created the expectation that central banks were determined to save the economy at all costs, stabilized asset prices. The stabilization of asset prices sustained investors’ confidence and kept the economy afloat.
Most European countries tried to save their economies from the GFC with an approach that combined super-low interest rates and proactive fiscal policy to issue more public debts, as Japan did in the 2000s. The United States is slightly different. In addition to using quantitative easing, it can incentivize global capital to flow into the US capital market for security by stirring up geopolitical tensions elsewhere.
However, while quantitative easing can inflate asset prices, it is not a solution to demand shocks – the real problem that crippled major economies. What’s more, economies have become addicted to quantitative easing. The financial institutions, with the expectation that they are ‘too big to fail’, lose incentives to correct their high-risk behaviours. The price was paid by taxpayers’ money in the form of austerity – a decline in welfare – and inflation – a rise in living expenses. This has depressed consumers’ demand even further, leading to lower production and still lower incentives on the capital side to invest in the real economy. It has also perpetuated a widening disparity between the poor and the super rich. The rich get richer with soaring asset prices, and the poor get worse off due to the inflation. This is exactly what happened in Japan; it is now taking place in many Western countries; and it may happen in China. What kept asset prices afloat was the unlimited supply of money from central banks, not real demand. The economy is artificially sustained with costs borne by the general population.
Is this time different, with Trump’s return to the White House?
Donald Trump has the agenda to reindustrialize the US. He believes that the US society is too divided due to de-industrialization and trade deficit with manufacturing countries such as China, Germany, and Japan. He wants the US to stop being the buyer of the last resort for China and other manufacturing countries. To reindustrialize the US, he will demand that the Fed lower the interest rate, so that the manufacturing sector of the US can become more attractive for investment. On the other hand, China is putting in place more proactive fiscal and monetary policies to prevent the economy from falling into a deflationary spiral. In light of Trump’s presidency, the People Bank of China has depreciated the Renminbi (RMB) against US dollars.
If the Fed were to keep the interest rate high, then capital would continue to flow out of China and other parts of the world and into the US. This will keep the US de-industrialized. By contrast, if the Fed were to cut the interest rate, then capital may flow to other parts of the world for higher investment returns. This will also keep the US de-industrialized – and with lower asset prices. The US is facing a lose-lose situation, and keeping a high rate is a ‘less bad’ option. At least that is what Jay Powell believes.
China’s situation is no better than the US. Raising interest rates is not an option at all, for it will further deflate the stagnated economy. The only thing it can do is to depreciate RMB and keep interest rates low. However, these measures do not seem very effective so far. The real estate bubble has been busted already, and new industries are yet to emerge. China is trying to stimulate consumption, but consumers’ purchasing power has been depleted by savings in the real estate market.
The world economy is still dealing with demand shocks. The US president-elect wants to alter the current global economic structure in which some countries produce while the US is the buyer of the last resort. China wants to move away from an export-oriented growth model, but it has not been able to revitalize consumers’ pockets and confidence.
Re-balancing the world economy needs collective efforts, yet the relations between the US and the world’s manufacturing states are marked by tensions and hostilities.
Political leaders and policymakers must think of creative ways to raise demand, rather than keeping asset prices inflated forever. Quantitative easing has proved a failed solution to demand insufficiency.
Where, then, is the way out? Honestly, we do not know, and we hope only that new demand is not created by wars.
Hai Guo, Associate Research Professor, IPP
