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Some Panglossian Prognostications

Ashoka Mody, the former IMF mission chief to Germany and Ireland, is bearish on global growth prospects in the near-future. I’m by nature optimistic, but Mody makes some fair points:

Europe’s extensive regional and global trade networks mean that its internal problems are impeding world trade and, in turn, global economic growth. In 2012, world trade expanded by only 2.5%, while global GDP grew at a disappointing 3.2% rate.

Periods in which trade grows at a slower pace than output are rare, and reflect severe strain on the global economy’s health. While the trauma is no longer acute, as it was in 2009, wounds remain – and they are breeding new pathologies. Unfortunately, the damage is occurring quietly, enabling political interests to overshadow any sense of urgency about the need to redress the global economy’s intensifying problems.

[…]

But even the world’s most dynamic emerging markets – including China, Brazil, and India – are experiencing a sharp deceleration that cannot be ignored.

Consider India, where growth is now running at an annualized rate of 4.5%, down from 7.7% annual growth in 2011. To be sure, the IMF projects that India’s economy will rebound later in 2013, but the basis for this optimism is unclear, given that all indicators so far suggest another dismal year.

[…]

Indeed, as the effects of stimulus programs wear off, new weaknesses are emerging, such as persistent inflation in India and credit misallocation in China. Given this, the notion that emerging economies will recapture the growth levels of the bubble years seems farfetched.

It’s very easy to read the facts above as a gloomy predicament the global economy, but I think that interpretation betrays a somewhat obsolete late-20th Century understanding of growth: the primacy of free trade. I’m a strong proponent of trade liberalization, and don’t doubt it has a big role to play in the coming decades, but it by the fact cannot be as earthmoving as it was.

A little history, first. Consider the economic dynamic in the late ’70s, when the South Korean miracle was well underway. While Korea trumped America in growth rate, America’s total growth in real terms was greater than Korea’s. The large income gap meant Americans could easily absorb Korean exports, and Korea could focus on exports rather than domestic consumption.

When there’s one very rich country and many poorer ones, liberalization leads to bountiful dividends. But three things are very different today:

  • China’s total growth, in absolute terms, is greater than America’s.
  • The trade-oriented miracles of the 20th Century were relatively unpopulated. China, India, and Brazil represent a much bigger chunk of the world and its economy. There is no way their growth can continue to be financed by rich-world imports.
  • Trade as a per cent of global GDP has boomed, as the world liberalized. There are diminishing returns to further specialization. No doubt free markets are a good thing, but we’ve eaten most of our free lunch. (For example, tariff barriers around the world have plummeted since the ’60s).

For this reason when Mody defines “severe strain on the global economy’s health” as “periods in which trade grows at a slower pace than output”, the economy will be tautologically unhealthy. Imports and exports can only reach a certain level before facing diminishing marginal returns, issues of national sovereignty, and optimal specialization.

Consider China, which represents a staggering proportion of all global growth and is the primary trader with a majority of countries. Government officials are acutely aware that to advance development, China will have to move to a domestic consumption, rather than investment and trade, oriented economy. In the process, China’s exports and imports might both fall – keeping its very strong balance constant – while domestic consumption increases rapidly. Global output would increase more than otherwise, ceteris paribus, and trade would fall.

And this isn’t necessarily a bad thing. A pessimist’s read of Mody’s passage is as the end of liberalization. But an optimist sees that trade as a low hanging fruit has, largely, been eaten – but many useful reforms remain. Capital market liberalization at the top of this list. Both India and particularly China have hinted at freer financial markets. I would be curious what Indian indicators, exactly, suggest “another dismal year”. Surely its deficits and balance of payments aren’t desirable, but in recent years India’s growth rate has shown some volatility. There’s no reason to believe next year’s growth won’t be much higher as North American growth accelerates.

India and China both have remarkable room for institutional improvements. Regulatory and labor deregulation in the former, and democratic pulses in the latter are bound to increase investor confidence and potential for future growth. Indian workers are also profoundly unproductive. Usually because capital intensity is dismal (anecdotally, when we stayed in Goa, India’s richest state, the autumn leaves strewn across our lawn were picked up by the hand one-by-one, not even a simple, Medieval, rake). But this is a good thing, supply-side reforms have a long way to go which, if done correctly, will temper inflationary pressures.

India will also be joining the relatively small club of countries offering inflation-protected government securities. This will substantially decrease the trade deficit from imported gold, and allow savings to be allocated towards productive ends. Further, while in hopes of American and European revival I would support fiscal stimulus, I don’t know whether I accept Mody’s suggestion for rich-world fiscal policy as global revival.

American and European debts are to a large extent financed by emerging economies. Rather, growing countries like India should structurally reform its central banking system and institutionalize independence; thereby decreasing perceived risk of government default. Today, the Reserve Bank of India is by many considered complicit in runaway deficits. Credible government policy would reduce long-run yields, and hence improve prospects for economic growth.

At this point in American recovery, growth should be financed by minting all the money that’s fit to print. Perhaps we need a New York Times op-ed on this.

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