NS3040 Winter 2015 Origins of The Global Economic Crisis.

NS3040 Winter 2015

Origins of The Global Economic Crisis

Overview

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Overview

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Factors MjContributing Mjto the U.S.. MjFinancial Mj

Crisis Mj

Factors MjTransmitting Mjthe Crisis to Mj

the rest of the Mjworld Mj

Global MjEconomic Mj

Crisis, Mj2008-09 Mj

Commodity MjMarket Mj

Developments Mj

Global MjInfluences Mj

Country MjResponses Mj

Patterns Mjof Mj

Recovery: Mj

Progress in MjEconomic MjReform/ Mj

Governance Mj

Country MjVulnerabilities Mj

Setback Mj2011 Mj

Chinese MjEconomic MjStresses Mj

Future MjScenarios/ MjInstabilities Mj

Increased MjInequality Mj

Debt MjLevels Mj

Security MjImplications Mj

Eurozone Mj MjInstability Mj

Short MjTerm MjRisks Mj

Medium MjTerm Mj

Scenarios Mj

Final MjAssessment Mj

Economic Crisis and Security Threats

“The global recession is America’s primary near-term security concern.”

Admiral Blair – Director of National Intelligence

(February 2009)

“The single biggest threat to national security is the national debt.”

Admiral Mullen, Chairman of the Joint Chiefs of Staff(August 2010)

“I have to confess, I paid no attention to this (economics) as a cadet and have done nothing to increase my awareness of economics issues between age 22 and 59. I should have paid attention.”

General Dempsey, Chairman of the Joint Chiefs of Staff (October 2011)

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The World Economic Crisis

• The current crisis while severe, shares many characteristics and patterns associated with past crisis

• Its origins and underlying causes follow a familiar pattern --- with several unique twists

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Characteristics of Financial Crisis

• All financial crisis share the same core elements:

• Some type of shock

• Its propagation (how it spreads – contagion)

• The broader impact

• The Underlying Causes

• Primarily microeconomic (e.g. bad banking)

• Primarily macroeconomic (e.g. recession)

• Primarily institutional (e,g. poor infrastructure or inadequate supervision)

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Crisis Overview: Vulnerabilities and Triggers

• U.S. Vulnerabilities

• Monetary and fiscal policies too loose to long

• Innovation and regulatory failure

• Excessive household debt and bank leverage

• Global Vulnerabilities

• Demand boom and inflationary pressures

• Housing and asset price boom

• Large and widening imbalances

• Triggers

• Subprime securities collapse

• Lehman failure

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Causes of the Current Crisis IOver the years the stage being set for the current crisis. Four

initial conditions critical.• 1. Assets were created, bought and sold that appeared

much less risky than they truly were.

• Early 2000s environment stable in most of world with sustained growth and low interest rates.

• Investors expected housing prices to continue their rapid increase.

• 2. Development of securitization led to complex assets on the balance sheets of financial institutions

• Major improvements in risk allocation,

• But harder to assess values than the case of simple mortgages

• Worries about the original mortgages translated into a large degree of uncertainty about the value of derived securities

• The fact that the securities were held by a large set of financial institutions implied that this considerable uncertainty affected a large number of balance sheets in the economy.

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Causes of the Current Crisis II

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Crisis Timetable

The economic crisis has evolved through several stages:

• Summer 2007 – initial phase• Subprime mortgage crisis, • Beginning of collapse of stock exchange

• Early 2008 – growing stress in advanced countries• Systemic crisis of financial intuitions in US• Economic slowing down in U.S. EU and Japan, but• Overheating inmost emerging markets (high commodity

prices, weak US dollar accelerating inflation

• Summer 2008 – breaking point• Bursting commodity and other bubbles• Global crisis of financial institutions (bankruptcy of Lehman)• Recession in developed countries

• Fall 2008 – crisis hits emerging market economies.• Effects of the crisis world-wide and more severe than in past

modern recessions – severe because of wide-spread financial institution’s holding of bad paper. 9

Economic Growth Rates

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Global Financial Crisis: Potential Security Threats

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Four Early Economic/Security Scenarios

In late 2008, early 2009 four economic crisis/security scenarios were getting considerable attention –

• The Vulnerability Effect – terrorists seeing the U.S. economy melting down calculate that a strike could have a force multiplier because of the already skittish stock market.

• The China Syndrome – Chinese own more than $500 billion in US. Treasury bonds, and billions more in other U.S. debt. While they would not dump them on the market to disrupt the U.S. economy, they have leverage over U.S. decisions on interest rates, exchange rate decisions.

• A Japanese “Lost Decade” – U.S. economy flat in the water for a decade or so – government runs up debt with no stimulating effect on the economy

• The Alternative-Dollar Nightmare – countries refuse to hold dollar reserves. Dollar crashes and U.S economy along with it.

• None happened – Lesson – Much More Stability in Global System than Commonly Believed

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Factors Contributing to Stability

Why didn’t the global system collapse when many in late 2008 were predicting its immediate demise?

• Revival did not happen because markets managed to stabilize themselves on their own

• Governments learning from the great depression responded quickly through central banks and treasuries

• The extensive social safety nets across the industrialized world cushioned the pain

• Global system is simply more resilient than we imagined – three major reinforcing elements producing stability

• Spread of great power peace – relatively little friction between major nations – rare in history – true global economy

• Relatively low rates of inflation – can plan for the future

• Technological connectivity – information revolution crated a deeply connected global system – most nations have benefitted greatly from the system – cautious about appeals to nationalism or acts that would jeopardize the current system. 13

Crisis: Potential U.S. Growth

The crisis will have a marked impact on U.S. potential growth:

• The recession, the rising U.S. debt levels and tighter financial conditions will hurt investment, keeping capital formation well below rates in pre-crisis years

• Resulting high and more-persistent-than-usual unemployment will lower potential growth

• IMF estimates that U..S. potential output will average about 1.5% over the next five years.

• This compares with an estimated 2.0 percent anticipated average in the absence of the crisis

• By 2014 the potential output expected to be abut 6 percent below what it would have been in the absence of a crisis

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Crisis Transmission and Responses

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Crisis Response• Not much coordinated activity in responding to crisis, because

of incompatible conceptual frameworks for understanding its root causes

• U.S. policy makers believe that trade surplus countries pursued policies that created global imbalances – excess savings in China – fixed exchange rate

• Europeans believed that the root cause of the crisis was excessively deregulated financial systems

• China feels reserve status of dollar created the imbalances to develop to unsustainable levels

• Therefore responses not coordinated

• Fiscal stimulus in some countries

• Expansive monetary policy, central bank asset purchases

• Support (IMF) to vulnerable countries

• Attempts through WTO at preempting protectionism

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Overview: Divergent Growth Recovery

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Crisis Recovery: Type I Countries

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Crisis Recovery: Type II Countries

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Crisis Recovery: Type III Countries

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Crisis Assessment October 2010

• Despite encouraging signs, still much uncertainty in the world economy

• Currently, the global recovery is looking like a U – but that could change quickly – several distinctive recovery patterns

• Economic repair is still incomplete and fragilities remain.

• Will private sector demand be strong when stimulus over?

• Will exit from stimulus policies be well timed and orderly?

• Premature retreat can kill the recovery; delayed retreat can raise inflationary likelihood

• Medium term growth for the world might be subdued

• Fiscal viability of the rich economies in in question

• Financial systems in rich countries are still impaired

• A slow expansion of world trade is likely in the context of rebalancing

• Possible adverse impact on developed country investment due to regulatory uncertainty.

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• Martin Wolf Assessment

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Crisis Impacts I

International Relations:• Potential effects on the U.S. leadership position

in the world • Enhanced role for the International Monetary

Fund, and Multilateral Development Banks – decline in U.S. influence in IMF policy.

• The rise of China as a player in international financial issues and the co-mingling of U.S. and Chinese financial interests

• Additional pressures on European unity and policy discord between the United States and Germany/France.

• Possible economic and political crisis in Eastern Europe and a tug-of-war for influence there between Russia and the EU/US.

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Crisis Impacts IIFundamental Philosophies• Rise of state capitalism and a questioning of the

Western economic model of deregulated, market-based decision-making

• Risk of rising trade protectionism and intensified anti-globalization efforts.

• Potential for more authoritarianism in countries such as China and Russia and or rise in authoritarian models of governance in the developing world.

Security• Rising poverty and potential political instability in

developing countries – fertile ground for recruits for extremism

• Budgetary pressures in Western nations could constrain international security and diplomatic efforts.

• More instability in poor countries -- Estimates are that the risk of conflict goes up 1 percentage point for each percentage-point decline in economic growth rates.

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Crisis Impacts III

Financial and Economic Fallout• Possible reduced U.S. financial primacy in the

world and importance of dollar as a reserve currency

• Diminished flows of economic assistance, capital and remittances to developing nations

• For developing nations, declines in export earnings from low prices for commodities and from shrinking world trade.

• Increased likelihood of espionage against both private corporations and U.S. government agencies – increased employee vulnerability

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Roubini Q3 2010 Assessment

Going into Q3 2010 global recovery remains in grip of extreme economic uncertainty and unprecedented financial volatility. Four main scenarios:

• V-Shaped global recovery (4% probability) imbalances increase as both surplus and deficit G10 and EM countries get back to business as usual.

• W-Shaped double dip (35%) with collapsing financing of imbalances precipitating cascading defaults around the world damaging both creditor and net debtor economies.

• U-Shaped anemic G10 and semi V-shaped EM recovery (52%) in which protracted balance sheet repair allows for gradual rebalancing/reduction of global macro imbalances.

• L-Shaped stagnation (9%) in advanced economies and U-shaped below potential EM growth due to a lack of adjustment among both debtor and creditor nations. 28

IMF Scenarios I

• Scenario 1: Global Cooperation to Rebalance World Output and Demand – Not much evidence of this

• Refocus of citizens and governments on sustainable domestic production and consumption

• Sustainability refers to patterns of work, investment and spending that do not rely on persistent, large international transfers of economic and financial resources.

• At the international level it means that international trade and financial balances should not be far from zero in either direction over long periods of time

• Scenario 2: Lack of Coordinated policy Adjustments – Global Imbalances Return – Seems to be playing out now

• Continuation of export led growth, especially in Asia could frustrate attempts by US to shift its economy away from excessive consumer and government borrowing and spending toward business investment and exports

• If we attempted this sift and the surplus countries continued export-led growth – U.S. would have at best a weak recovery 29

IMF Scenarios II

• Scenario 3: No Policy Adjustments and Premature Withdrawal of Macroeconomic Support– Global Slump Returns – not widespread – Eurozone?

• Assumes no progress toward economic restructuring while policymakers misjudge the strength of economic recovery

• If government policies that have resulted in large budget deficits and near-zero short-term interest rates – which probably kept the global economy out of a depression are reversed – and if private sector spending slows unexpectedly, economies could fall back into a slump as bad as 2008-09

• Result in a double-dip global recession with policy responses even more drastic than the first downturn.

• Further long-lasting economic damage in form of long term unemployment and financial defaults would occur.

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Global Recovery Consensus

Despite diverging interpretations over the pattern of recovery, most analysts agree that:

• The global economy has been significantly affected by the financial crisis

• Emerging economies will outpace growth of the advanced economies. This disparity in growth has only been exacerbated by the financial crisis.

• Commodity prices are also set to rise, which could further frustrate gains in GDP as well as affect security.

• Debt will rise and revenues will fall for the governments of the advanced economies, while emerging economies will be more financially sound.

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Crisis Impact on Defense Spending

Global financial crisis and the subsequent recession in most European countries has created a new dynamic for defense spending

• Even before the crisis punishing demands of operations on armed forces revealed shortfalls in capabilities

• In addition the cost of new equipment was rising at a rate of 5-10% per year.

• As both trends continue, European governments now struggling to control public deficits have launched a series of austerity measures across the board.

• In the overall scheme of government priorities, defense spending has become discretionary and many defense ministers have already been asked to make do with less money

• Two basic options in light of these developments

• Accept that reduced financial resources will lead to reduced capabilities

• Use the budget crunch as an opportunity to do things differently32

Defense and Austerity• Most elements of defense policy are likely to experience major

changes.

• UK government has suggested defense expenditures might be cut between 10% and 25% over the next few years

• France is considering cuts of $2.6-$6.6 billion over the next three years.

• Germany – Finance Ministry has demanded reductions totaling 4.3 billion Euros for the period 2011-14.

• Italy and Span have slashed budgets as have a range of smaller EU member states.

• So far these cuts have not been coordinated on the European level which increases the likelihood that an overall reduction of European capability will be the result

• In late July 2010 France and Germany were first countries to announce coordinated discussions about cuts.

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Patterns of Military Expenditures

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Projected Changes in Defense Budgets: 2010-2015

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Spending Cuts Hit Foreign Aid

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CBO Defense Budget Estimates

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Is Health Care the Worst Threat to U.S. National Security?

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Implications for U.S. Security

One key outcome of the Crisis – Lower Growth and Higher debt – Greater Threat to Security than Concerns at Start of Crisis

• Financial constraints will play a considerable role in structuring U.S. policy in the foreseeable future

• When debt levels reach 90% or more of GDP, the U.S. may find that its rate of growth slows by 1% per year (ring of fire diagram)

• The fiscal squeeze that the U.S. and other advanced economies may experience can have the ability to crowd out discretionary spending – defense budgets under considerable stress.

• As a result the ability for advanced countries such as the U.S. to spend increasing shares of GDP on defense and security may ---- even to respond to threats may be extremely limited.

• In the longer term the U.S. is likely to find that its traditional allies are declining in relative economic and military strength.

• Similarly, the U.S. will find it has to deal more and more with countries that it traditionally has not had shared common interests

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Summing Up

Key Points• The global economy has been significantly affected

by the financial crisis• Emerging economies will outpace the growth of the

advanced economies. This disparity in growth has only been exacerbated by the financial crisis

• If commodity prices increase over the next several years it would further reduce slow DMs and perhaps some EMs

• Debt will rise and revenues will fall for the governments of advanced economies while emerging economies will be more fiscally sound

• U.S. and other DM countries will most likely experience a lower rate economic growth than it has in the past creating greater fiscal stresses

• The fiscal stress in the advanced economies may significantly reduce defense expenditures and other discretionary items.

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