Policy

Can the global economy avoid a crisis?

     
February 26, 2016

From: Magazine

Every month, The Big Question video series brings together a panel of experts for an in-depth discussion. In this edited excerpt from January’s episode, Chicago Booth’s Randall S. Kroszner and Amir Sufi were joined by James Robinson of Chicago Harris in a conversation about the global economy. The discussion was hosted by Hal Weitzman, Booth’s executive director for intellectual capital.

Weitzman: How concerned should we be about China’s impact, particularly its financial sector, on the global economy?

Kroszner: By trying to defend the stock market, they’ve dramatically increased the exposure of the entire financial system to it. The downturn of the stock market came when they introduced a sensible macroprudential policy, trying to take some of the air out of the bubble, to rein in “shadow bank” lending used to purchase stocks. But once the market turned south, they reversed course and said, “Let’s continue to lend and maybe increase lending. Let’s make sure everybody buys and let’s not permit people to sell.” Now, the insurance companies, the banks, the securities firms have greater exposure to the stock market than they had before. That makes things more fragile.

Sufi: McKinsey Global Institute put out a report showing China led the world in growth in debt-to-income ratios for the financial sector from 2007 to 2014, and that it’s third in the expansion in corporate debt and fourth in household debt-to-income ratios. So China has followed the exact model that we know historically leads to severe economic downturns: huge increases in debt to finance housing booms and consumer durables. The question is, will China do poorly, or terribly? People point to China’s large reserves, and note that China is a planned economy. I’m not particularly convinced by either of those arguments. It helps that they’re running current-account surpluses and have extra reserves at the central bank, but the same was true of Japan in the late 1980s, and it looks a lot like what happened there: big increases in commercial real-estate prices and investment. That leads me to worry that you’re going to see a pretty severe economic downturn in China.

Kroszner:
Although they have a lot of reserves, you can blow through those reserves relatively quickly. At $100 billion a month, which seems to be what they’re doing, even with $3 trillion worth of reserves, that doesn’t last all that long. And once the markets see that you’re going to blow through that, they start questioning things.

Sufi: There are two numbers that are quite scary. First, electricity consumption had 25 percent year-over-year growth in 2010, 15 percent in 2012, and 0 percent in 2015. That’s worrisome. Second, freight capacity (and quantities being shipped) is down 11 percent year over year, the worst reading in its history of being measured. Whenever people have built far too many buildings, and bought too many cars and houses they can’t afford, that usually portends bad things.

Weitzman: Can China achieve long-term economic growth without fundamental political reform?

Robinson:
No. The bigger problem in the long run for China is the businessmen who disappear for a few days, with nobody knowing where they are, and then reappear. That’s an example of China’s fundamentally unreformed autocratic political system. You can’t build a modern, successful, prosperous society with such a ridiculous concentration of political power. If you look back through history, there are instances where if the people at the top decide, “This is OK. We can push for this.” It works for a while, for 10, 20, or 30 years even. When I was an undergraduate in England, we learned that the Soviet Union was the economic model to follow. The Soviet Union did very well for 40 years. Of course, there are plenty of differences between China and the Soviet Union, but you have to reform the political model in China if you want to have enduring prosperity.

Weitzman: Is there any appetite for fundamental reform?

Robinson:
Absolutely not. Quite the opposite. They think they can adjust, by implementing an anticorruption drive and term limits for people at the top. They’re trying to figure out what will help them stabilize their power, but they have no intention of giving power away. Even local elections are just a way of trying to figure out, “Could this help us stabilize power? Could it help us select better people for the party?”

Weitzman: More generally, when times are bad, is economic reform more likely?

Robinson: You can find examples of countries that have reformed in a crisis; but you can find lots of other examples of countries that have disreformed in a crisis. Think about Argentina. A massive crisis brought the Peronists and Kirchner back to power. They spent the whole time reversing many improvements, renationalizing things, taking a grip on the agricultural sector, undermining the bureaucracy, preying on the private sector, and controlling prices. A crisis brought this political machine back to power, so you could make the opposite argument. When things are going very badly, this clientelistic way of doing politics has more traction with poor people, who are even more reliant on the state for handouts and favors.

Weitzman: With former economic superstars such as Brazil and China slowing down, what does that mean for developed countries? Can the United States carry the global economy on its own?

Kroszner: The US is a big trading partner in the world, but it doesn’t depend on the rest of the world as much as other countries do, so the challenges in the rest of the world are not going to have as much of a negative impact on the US as they might have on other countries. The US has grown steadily through the last few years at about 2 to 2.25 percent growth. We’ve been in what I call a “sideways slide” despite both positive and negative shocks along the way. That seems likely to continue. Obviously if there is a crisis in the Middle East or in China, that could have an impact on the US.

Sufi: I agree with Randy. The direct exposure of the US in terms of a cash-flow calculation is quite low. But how would a severe downturn in many emerging markets affect the US? The effect will come through an asset-price channel. Asset prices are a function of expected cash flows, and the discount rate used to discount those cash flows. The actual cash flows probably won’t adjust much, but my concern is that the discount rate may dramatically change in the US because of concerns of what’s going on in emerging markets. This is what’s called the “risk premium effect.” Think of it as people getting scared. If you look at the single day reaction, for example, when the Chinese stock market had a major correction last August, the S&P 500 fell 10 percent over three or four days. You could never justify that from changes in what we thought the cash flows of the US were going to be. The only way China can affect the US stock market so dramatically is if people are worried about the world in general and therefore use a higher discount rate to discount those cash flows.

Weitzman: How could rising US interest rates affect struggling developing economies?

Kroszner: There’s been a lot of garment rending over this in the last year or two, but it’s largely been anticipated that the Fed would begin to raise rates, and that’s helped to reposition countries and markets to be ready. Some have reformed; some haven’t, so they’re still going to be hit. The Fed is going to be on an extremely gentle path. I see little prospect of inflation in the near-to-intermediate term. Without more inflation coming back in, it’s likely to be a long time before the Fed takes the next step.

Weitzman: What effect could immigration have on economic growth in developed countries?

Robinson:
I tend to think of it as being great for economic growth. After all, who are these people? They have overcome immense barriers to get out of where they were and move somewhere else. The edge that the US has over everywhere else is its immense welcoming of foreigners. That’s not true of Britain or China. The US has been able to suck talent and entrepreneurship and ideas into it for a couple of hundred years, and that’s a huge part of the story of its economic success. You see the panic of Europe. They just don’t know how to deal with it. You see the rise of xenophobia. But the terrorists who blew up the World Trade Center didn’t come in a boat to the US. They flew business class. Terrorists are always going to wheedle their way in and do damage if they’re obsessed and determined enough. We have to deal with that, but immigration has lots of potential economic benefits.

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