ECONOMIC AFFAIRS: by Patrick J. ByrneNews Weekly
Behind the trade-induced global financial crisis
, December 24, 2011
The global economic crisis has created civil and political unrest across Europe and the US, while in the Middle East newly educated, angry unemployed youth are bringing down old military autocracies.
World-wide unemployment is 210 million, the highest in history, with the world needing to create another 440 million jobs in the next decade for new workers entering the global workforce, according to the International Monetary Fund. So the world will have to find a total of 650 million jobs in 10 years. Already, the highest unemployment is among youth. (Dominique Strauss-Kahn, “Saving the lost generation”, IMFdirect, September 14, 2011).
The ability to create new jobs and to avoid global political turmoil is now under threat because the world is in the grip of the second Great Contraction in the history of industrial, market capitalism, according to Kenneth Rogoff, professor of economics and public policy at Harvard University. (“The second great contraction”, Project Syndicate, August 2, 2011).
Just as the Great Depression of the 1930s created political turmoil — laying the grounds for totalitarian threats to democracy from both the left and the right — so too this economic crisis will have far-reaching economic, political and strategic implications.
Ironically, today’s unemployed youth in the West are protesting at the failure of democratic governments to prevent and then solve the economic crisis, while unemployed youth in the Middle East are overthrowing their old regimes and looking to the ones that have replaced them to provide them with jobs.
Capitalism’s international financial and global trade systems, developed since the 19th century industrial revolution, have proved to the highly unstable. Their instability helped precipitate the Great Depression, which generated a cascade of events that resulted in World War II.
After the war, global governance mechanisms were created aimed at stabilising the world economy — the General Agreement on and Trade Tariffs (GATT) regulated international trade, and the Bretton Woods agreement regulated exchange rates between members of the Western alliance.
However, since 1980, the globalisation policies initiated by Britain’s Prime Minister Margaret Thatcher and US President Ronald Reagan have stripped away many of these global governance mechanisms.
The resulting instabilities have produced a global economic crisis.
Depression, not recession
Despite repeated economic crises over the past 30 years, economists repeatedly ruled out the possibility that the world could ever succumb to another 1930s-magnitude depression.
Around the world, economics and business schools taught today’s politicians, economists and policy formulators that the days of prolonged slumps were over. At worst, their economies might suffer no more than capitalism’s periodic, short-lived, shallow recessions at the end of each business cycle.
Consequently, many economists have wrongly labelled the sizable economic crisis of 2008, which produced the sharpest fall in economic output and jobs in recent generations, as “the great recession”.
This terminology is wrong. The current downturn is not a recession; it’s a depression, argues Kenneth Rogoff. Consequently, policy-makers worldwide, who have never experienced or had to deal with a full-blown economic depression, are struggling to understand either the causes of the crisis or how to restore economic growth and stability to the global economy.
As Rogoff argues, calling it the great recession “creates the impression that the economy is following the contours of a typical recession, only more severe — something like a really bad cold… [Hence] forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong.
“Moreover, too many policy-makers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.
“In a conventional recession, the resumption of growth implies a reasonably brisk return to normalcy. The economy not only regains its lost ground, but, within a year, it typically catches up to its rising long-run trend.”
This crisis is different from the recessions of the past 70 years. It’s the difference between a common cold and full-blown pneumonia.
A recession is defined as three consecutive quarters of negative economic growth. It’s then followed by governments lowering interest rates and boosting government expenditure to produce a recovery to normal economic growth in one or two years.
There is no clear definition of depression, but it broadly means a sharp fall in economic output after which the economy stagnates long into the future, well below the level of output prior to the depression. It produces prolonged, high unemployment.
What also distinguishes it from a recession is that a depression is caused by very high levels of national debt (government, private sector or both) that suppresses economic growth. Growth is not restored until this debt is paid off, which can take a decade or longer.
The Great Depression lasted roughly from 1929 until the onset of World War II in 1939. A whole generation experienced long-term unemployment, leaving millions in poverty and pushing down the marriage rate and birth rate. In the US, unemployment averaged around 18 per cent during the 1930s.
The lost decade of economic growth produced a lost generation of young people.
Three years after the 2008 global financial crash, many world leaders are now admitting that today’s crisis could take a decade or more to resolve.
Figure 1 shows the huge debt burdens weighing down our major Western economies. Whether it will take a decade or two decades to reduce this burden and restore economic growth is uncertain.
Assuming that the major economies were growing at around 2 per cent a year until the 2008 crash, then three years after the crisis began:
• the economies of the US, Japan and Italy are 5–7 per cent below what would have been anticipated had the crisis not occurred; and
• the United Kingdom, Germany and France are a massive 10–12 per cent below what would have been anticipated three years ago. (Based on data from the UK Financial Times, 2011).
Consider what this means for the UK. During the Great Depression, the UK cumulatively lost 17.7 per cent of gross domestic product. At the current rate, by April 2012, the UK’s cumulative losses will surpass the losses from this depression, according to Financial Times economist, Martin Wolf (“The UK must escape its longest depression,” Financial Times, Sept 1, 2011).
The global depression is already generating social and political unrest. It will negatively impact on the global economy at the same time as millions of new workers will be looking for jobs.
Rising global unemployment
Given that the International Monetary Fund estimates that 650 million new jobs will need to be created over the next decade for the expanding global workforce, a prolonged global depression will see unemployment rise to levels not seen since the 1930s Great Depression.
Already, as Figure 2 shows, youth unemployment in the US is around 18 per cent, on a similar scale to Middle Eastern countries.
In the Middle Eastern countries, about half the population is under the age of 25. Whereas a generation ago they lacked education, today many are unemployed university graduates. Having a permanent job is the necessary condition for young Arabs to buy a house and, in turn, marry and form a family.
The old regimes provided education systems for their youth, but they have failed to build economies that can provide jobs for them. Consequently, widespread youth-led protests are seeing these old regimes crumble.
In the US, approximately half the unemployed are long-term unemployed. The difference between today’s crisis and the 1930s Depression is that the welfare state provides a safety net that prevents the unemployed in Western nations from falling into abject, mass poverty.
The loss of higher-paid manufacturing jobs across the developed world has forced workers, who were once in highly-skilled, well-paid industrial jobs, to find work in service industries that, on average, pay less than manufacturing jobs.
The loss of these jobs in the developed Western countries has been the result of two factors — globalisation of the world economy and rapid technological change, according to a major paper for the International Monetary Fund (see Florence Jaumotte and Irina Tytell, How Has The Globalization of Labor Affected the Labor Income Share in Advanced Countries?, IMF, 2007).
According to the IMF, globalisation saw a vast expansion of the world’s labour supply as the newly emerging economies became part of the global economy. This forced workers in advanced Western economies into competition with low-wage workers in East Asia, China, Eastern Europe, Russia and Latin America.
At the same time, automation has reduced the demand for manufacturing jobs worldwide, just as the mechanisation of US farms 100 years ago saw a huge fall in demand for farm labourers. As they shifted from rural areas into the cities, they were absorbed into higher-paid manufacturing jobs.
In contrast today, as high-paying manufacturing jobs disappear in developed economies, most workers are forced into lower-paid service industries, or become long-term unemployed.
However, today’s developed nations have yet to find high-paying job solutions for workers losing their traditional jobs in manufacturing.
The future for these workers remains grim, as the global economic crisis is set to deepen as the insoluble crisis of the European Union threatens a second international financial system crash.
Hence, at a time when the global demand for jobs is rapidly rising, the depression gripping the major economies is preventing the creation of new jobs and adding to the world-wide growing pool of unemployed.
The rising tide of global unemployment comes on top of three decades of growing inequality in the developed economies of the US, Europe and Australia.
In the US, labour’s share of business income has fallen from 63 per cent in 1990, to 58 per cent in 2005. That 5 per cent fall in labour’s share of business income amounts to $US500 billion a year in lost wages. In other words, if labour’s share hadn’t fallen, labour’s income would be $US500 billion higher this year, according to Peter Orszag, vice-chairman of global banking Citigroup Inc. (Bloomberg, October 19, 2011).
If the comparison was taken back to the early 1980s, when the policies of economic globalisation began, the fall in labour’s share of the economic pie would be even more pronounced.
Similarly, between 1995 and today, labour’s share of the economic pie dropped 4 per cent in Germany and France and 6 per cent in Australia and Japan.
Nobel Prize-winning economist, Paul Krugman, points out that in the first age of globalisation, prior to World War I (also called the Gilded Age of the United States), tycoon John D. Rockefeller made US$1.25 million in declared income on his tax returns for 1894.
That was 7,000 times the average per capita income in the United States at the time.
“But that makes him a mere piker by modern standards,” says Krugman. In 2007, just before the current crisis, “according to Institutional Investor’s Alpha magazine, James Simons, a hedge-fund manager, took home $1.7 billion, more than 38,000 times the average income.
“Two other hedge fund managers also made more than $1 billion, and the top 25 combined made $14 billion.
“How much is $14 billion? It’s more than it would cost to provide health care for a year to eight million [American] children — who, unlike children in any other advanced country, don’t have health insurance,” said Krugman (New York Times, April 27, 2007).
Nicholas D. Kristof (New York Times, October 15, 2011) says that the CIA’s own ranking of countries by income inequality shows that this disparity of income has left the United States a more unequal society than either Tunisia or Egypt.
He says that underscoring the rise of inequality, the top 1 per cent of Americans possess more wealth than the entire bottom 90 per cent, and in the Bush Administration’s expansion from 2002 to 2007, 65 per cent of economic gains went to the richest 1 per cent.
Inequality matters to families and to the economy.
As labour’s share of the economic pie declined, US households borrowed from the banks that borrowed from the trade surplus countries, such as China and the oil-exporting nations, to buy homes and consumer goods.
Until the 2008 crisis, US households were, on average, spending 110 per cent of their annual income. In order to maintain a property-owning democracy, the US banks were required to ease their lending rules to what became the high-risk, sub-prime mortgage market. Its collapse triggered the global financial crisis (GFC).
Inequality also impacts on the manufacturing and retail sectors of the economy. A US or Russian billionaire will buy one iPad or one smart phone. But currently, only one-third of Americans own a smart phone, because they are too expensive for many wage-earning people.
However, if the US middle-class had the same share of the pie as they had in 1990, i.e., $500 billion more in wages annually, the US would be selling far more smart phones and iPads.
The point is that a more equitable distribution of income stimulates greater demand for consumer goods and services, greater investment in research and development, and greater innovation — far more than a nation with an inequitable distribution of income.
Greater equality also means more people owning their own home with lower risk of mortgage default, and more who can marry and raise a family.
In contrast, high unemployment and greater inequality of income are strongly associated with lower home ownership, lower marriage rates, family breakdown, substance abuse, crime, social dysfunction and higher dependence on the taxpayer-funded welfare state.
Solutions to unemployment and the widening inequalities of in wealth and income are yet to be resolved.
Solving the global economic crisis — which appears to be a long way off — would generate more jobs, but more so in manufacturing powerhouses like China rather than in the developed economies.
In the Western countries, there have been many calls from policy-makers and economists for more education and greater skills training. This begs the question — education and training for what jobs?
The US could use various protectionist means to increase domestic production and rely less on imports. But, given that technological advances and automation have reduced the need for manufacturing labour, just as new technology reduced the demand for farm labour a century ago, more education could only partly solve America’s unemployment problem.
Service industries tend to pay lower wages, and it’s not clear that there are new, higher-paid service industries capable of being created to absorb all those once employed in manufacturing.
Redistributing income and wealth from the top 1 per cent of Americans may help, but it’s no substitute for well-paid, middle-class employment. There has also been strong resistance to increasing taxes on America’s high-income earners.
The problem of unemployment and inequality is inextricably linked to the fundamental causes of the GFC.
Trade-induced financial crisis
Just as it’s incorrect to call the current crisis a mere recession, when in reality it’s a full-blown depression, it’s equally misleading to regard this only as a “global financial crisis” when it’s actually a “global trade-induced financial crisis,” a fact to which economists have now given adequate recognition.
It was originally called the global financial crisis (GFC), following the collapse of the US subprime mortgage market. US housing lenders Fannie Mae and Freddie Mac have since been nationalised; investment banks Lehman Brothers and Merrill Lynch vanished; and a giant mortgage insurer AIG had to be bailed out. The remaining household names on Wall Street, Morgan Stanley and Goldman Sachs, have been under siege.
Subsequently, by the end of 2009, Europe and the United States alone spent a total of US$9 trillion — that is, one-sixth of the world’s annual economic output — on bail-outs of financial institutions. That sum is all paid for by taxpayers.
The question few have asked is: what was the primary cause of the global economic crisis?
Martin Wolf of London’s Financial Times (“Creditors can huff and puff, but they need debtors,” Financial Times, November 1, 2011) is one of the few who correctly diagnosed the primary cause of the global crisis as resulting from the huge global imbalances in world trade.
To support his view he has cited a recent speech by the governor of the Bank of England, Mervyn King, who said: “Persistent trade surpluses in some countries and deficits in others did not reflect a flow of capital to countries with profitable investment opportunities, but to countries that borrowed to finance consumption or had lost competitiveness.
“The result was unsustainably high levels of consumption (whether public or private) in the US, UK and a range of other advanced economies and unsustainably low levels of consumption in China and other economies in Asia, and some advanced economies with persistent trade surpluses, such as Germany and Japan.”
Put differently, a group of big exporting nations — mainly China, Germany, Japan and the oil-exporting nations — ran up huge trade surpluses in the trillions of US dollars and Euros. These surpluses were created in several ways.
First, the East Asian Tiger economies embarked on a policy of hoarding huge trade surpluses after the 1997 East Asian economic crisis. During this crisis, the International Monetary Fund (IMF) demanded stiff austerity measures be pursued by these countries, after a flight of capital sent their economies into steep decline.
In response, they vowed never to be dependent on the IMF again. Instead, they manipulated their exchange rates to create trade surpluses which they saved as an insurance against any future hot flows of capital out of their economies.
Second, China used mercantilist policies to artificially keep its exchange rate low, giving it a huge protectionist advantage over developed nations with higher valued currencies and higher wages. This policy attracted industry and advanced technology from the West, turning China into the manufacturing power-house of the world.
Third, the creation of the Euro as the currency for the European Union in 2000, greatly advantaged Germany, turning her into a major exporter to the rest of the EU. Countries such as France, Greece, Italy, Portugal and Spain could not compete with German industries. They ran up trade deficits, while Germany and the Netherlands ran huge trade surpluses, then lending their surpluses back to those EU countries with the trade deficits.
Fourth, the oil-exporting countries — Saudi Arabia, Russia, Norway, Kuwait and Qatar — command one of the world’s most vital resources. Oil exports have created huge trade surpluses for these nations.
On the other side of the equation, the US, many EU countries and Australia saw their manufacturing industries move offshore to China and East Asia. These Western nations went into trade deficit, importing back from the East goods that they no longer produced at home.
The trade-surplus, exporting nations such as China could not just hoard their surpluses. They invested them, via the global banks, back into the trade deficit nations, such as the US. In the process, the global banks made huge fortunes in handling this money.
Consider how these funds were used in America. The US borrowed funds (running up a huge national debt) from the surplus nations, to lend first to consumers to buy consumer goods from China, and second to households to buy a home. As middle-class incomes had declined, partly due to jobs lost to China, banks had to increasingly lend to higher risk, sub-prime households in order for the US to preserve a property-owning democracy.
By the time of the crisis, US households were spending 110 per cent of their annual income as they attempted to maintain their falling standard of living. Eventually, the sub-prime mortgage market went into meltdown, precipitating the 2008 global crisis.
Hence, it’s vital to understand that it was the huge trade imbalances across the globe, the combination of trade surpluses and trade deficits, which in turn generated huge capital flows around the world which went into increasingly risky investments, eventually precipitating the GFC.
The financial crisis was created by massive global trade imbalances.
The lesson needs to be learned that all countries lose from such global trade imbalances. The deficit/debtor countries lose because their debts are too large to repay. The surplus/creditor nations suffer losses because their loans to the debtor countries can’t be repaid.
Everybody helped make this economic mess, and now everybody has to play their part in fixing it.
Global trade solution
Any solution to the global crisis will demand major rebalancing of global trade between nations.
Unless this occurs, invariably the global banks will be called upon to continue lending funds from big trade-surplus nations to many high-risk investments in trade-deficit nations.
No amount of regulation of the banks will stop such bad investments. The amount of funds involved is so large, that banks being banks will find ways around global investment and banking rules.
In the future, can some semblance of balance be restored to global trade?
There is no clear policy solution on the horizon. However, it can be said that if there is a determined will on the part of the major trading nations, a way can be found.
After the disasters of the Great Depression and World War II, which destroyed millions of lives and the livelihoods of millions more, the Western nations recognised that a way had to be found to achieve balances in trade and stability of exchange rates in order to bring prosperity and order to the global economy.
In the 1940s a series of arrangements led by the US were put in place to achieve these ends:
• the General Agreement on Tariffs and Trade (the GATT, now the World Trade Organisation) aimed at regulating trade flows;
• the Bretton Woods agreement gave stability to exchange rates; and
• other agencies, such as the World Bank and the International Monetary Fund (IMF), were formed to aid development and assist in financial and trade crises respectively.
It’s important to understand that these post-war agreements and organisations, particularly the Bretton Woods agreement and GATT, were designed not only to bring stability to the global economy, but to ensure that democratic nation-states would be able set their own economic policies in the interest of their own citizens, i.e., to guarantee the economic sovereignty of nation-states.
This was a vital part of the post-war social contract — governments would guarantee that as productivity of workers and industry rose there would be a fair distribution of income, while the welfare state would ensure that the unemployed, disabled and elderly were guaranteed a fair standard of living.
Or, as President John F. Kennedy once succinctly phrased it, a rising tide would lift all boats, even if some rose higher than others.
That post-war, international architecture broke down, beginning in the 1970s when the US ended the Bretton Woods agreement. Then key aspects of global governance were dismantled by the policies of globalisation.
Today, a new global trade and exchange-rate architectures is needed to restart economic growth, to bring stability to the world economy and to restore economic sovereignty to national governments.
However, apart from greater regulation of banking, there is strong resistance to new forms of global governance. The big surplus trading nations such as China and Germany want the system to keep delivering huge trade surpluses to their economies, even though this destabilises the global financial system.
The global banks are making vast profits annually from being the agents for these huge financial flows around the world.
Global production companies, once national icons, are today truly global multinationals. They have a vested interest in maximising profits by investing in low-wage, low-tax, low-valued currency countries like China and the Asian Tigers, not in delivering global trade balances.
Further, the global banks and multinational production companies control enough income and wealth to influence democratic Western governments to maintain the system in their interests, rather than the interests of nations and their citizens.
The advocates of globalism — the deregulation of the global trade, financial and labour markets to allow the maximisation of corporate profits — forgot the lessons of the Great Depression that led to the ordering of the post-World War II global economy.
Economist Dani Rodrik, professor of political economy at Harvard University’s John F. Kennedy School of Government, outlines the competing interest that constitute “political trilemma” of the global economy (Project Syndicate, May 11, 2010).
He said: “Economic globalisation, political democracy and the nation-state are mutually irreconcilable. We can have at most two at one time.
“Democracy is compatible with national sovereignty only if we restrict globalisation [i.e., a replication of the post-WWII period, with regulated global trade and exchange rates maintained by the GATT and Bretton Woods agreement ].
“If we push for globalisation while retaining the nation-state, we must jettison democracy [i.e., Beijing’s totalitarian model that ensures wages are kept low for the benefit of globalisation and centralised control by the nation-state].
“And if we want democracy along with globalisation, we must shove the nation-state aside and strive for greater international governance.”
The latter case describes the predicament of Western democracies, where governments can no longer effectively manage their open, globalised economies to guarantee the postwar social contract, especially full employment and an adequate welfare system.
Following the policies of globalisation, in the absence of adequate and effective global governance, national economies are at the mercy of the global economy.
Global alarm bell
A global reaction has already set in. Joseph Stiglitz, a professor at Columbia University, a Nobel laureate in economics, and the author of Freefall: Free Markets and the Sinking of the Global Economy, said recently: “The protest movement that began in Tunisia in January, subsequently spreading to Egypt, and then to Spain, has now become global, with the protests engulfing Wall Street and cities across America.…
“And social protest has found fertile ground everywhere: a sense that the ‘system’ has failed, and the conviction that even in a democracy, the electoral process will not set things right — at least not without strong pressure from the street.
“In May, I [Stiglitz] went to the site of the Tunisian protests; in July, I talked to Spain’s indignados; from there, I went to meet the young Egyptian revolutionaries in Cairo’s Tahrir Square; and, a few weeks ago, I talked with Occupy Wall Street protesters in New York. There is a common theme, expressed by the OWS [Occupy Wall Street] movement in a simple phrase: ‘We are the 99%’ …
“The protesters have been criticised for not having an agenda. But this misses the point of protest movements. They are an expression of frustration with the electoral process.
“They are an alarm.”
Patrick J. Byrne is vice-president of the National Civic Council. (An abridged version of this article appeared in the printed edition of News Weekly).