How to see the world economy through two crises
Martin Wolf | Saturday, 28 June 2008
TWO storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one. Last week I argued that exchange-rate regimes were a link between these distinct events. This week, let us look at how to sail on these storm-tossed seas.
The place to start is with the world economy as a unit. The more globalised economies become, the more appropriate it is to think of the world economy in this way. So what have we learnt about the world economy as a whole? The answer is that it is running into limits on resources, at least in the short term.
Our civilisation is based on fossil fuel. But since the end of 2001, the real price of oil has risen some six-fold. Today, the real price is higher than since the beginning of the previous century. As the World Bank (WB) notes in its Global Development Finance 2008, global oil supply stagnated in 2007. This, argues the report, "contributed to the large decline in stocks in the second half of 2007 and to sharply higher prices". These increases may prove temporary, as happened after the spikes of the 1970s, or permanent. We do not yet know.
Jumps in energy prices have at least three effects on the economy.
First, they increase headline inflation. In emerging economies, above all, bad inflationary surprises have become the norm.
Second, they lower potential supply, by squeezing profits in energy-consuming activities, forcing businesses to scrap energy-intensive capacity, and making it necessary to invest in new and more energy-efficient capacity.
In its latest Economic Outlook, the Organisation for Economic Co-operation and Development (OECD) discusses the consequences of such a negative supply shock on member countries. It makes two large points: first, uncertainty about current levels and future growth of potential output has risen; and, second, the adverse effects of this may be sizeable.
The OECD estimates that the recent rise in the relative real price of oil has lowered steady-state output by 4.0 per cent in the US and 2.0 per cent in the eurozone and lowered potential growth, in the medium term, by 0.2 percentage points and 0.1 percentage points, respectively. This is not trivial: in the case of the US, the decline in the growth of potential output must be at least 10 per cent of potential growth in output per head. In the more advanced emerging economies - and particularly a fast-growing industrialising economy like China - the reduction in the potential rate of growth may well be greater still.
Third, energy price jumps alter the level and distribution of global demand. The move from a price of close to $53 a barrel at the beginning of 2007 to $136 now, increases the annual cost to consumers by around $2,600bn annually, which is a tax of about 4.5 per cent on global non-oil output. Some two-thirds of this transfer is from oil-importing to oil-exporting countries. It is also from those who spend to those inclined to save, at least in the short term.
This shift itself will curb the rise in global demand. So, too, will the financial crises in the US and other high-income countries and the closely related collapse of several huge house-price bubbles. In the high-income countries, growth is forecast by the OECD to slow to a little below trend this year and next. As one would expect, the biggest decline is in the US, with gross domestic product (GDP) growth of 1.2 per cent this year, almost all of which is expected to be contributed by the rise in net exports. From being a locomotive of growth, the US has become dependent on growth elsewhere.
Yet will this decline in the rate of growth in the high-income countries cool an overheated world economy sufficiently? Perhaps not. The OECD expects a decline in growth outside the OECD, but to levels still above (a hard to measure) potential. The World Bank's Global Development Finance does expect a marked decline in developing country growth, though to still high levels, from 7.8 per cent in 2007 to 6.5 per cent this year and 6.4 per cent in 2009. Chinese growth is forecast to slow from 11.9 per cent in 2007 to 9.4 per cent in 2008 and India's from 8.7 per cent to 7.0 per cent.
Yet, as I argued last week, global monetary policy is probably too loose, despite the adverse impact of the credit crisis on high-income countries. In many emerging countries output is growing quickly, with inflation rising strongly. If, as seems likely, the world economy cannot grow as fast as people hoped only a year or two ago, emerging economies have to be part of the adjustment. This will become still more obvious when, at last, the high-income countries recover fully.
Against this difficult background, what are the right responses and how should they be distributed, across the globe? These need to be divided into the short term and the longer term.
In the short term, the biggest monetary policy requirement is a tightening in emerging economies, many of which now have strongly negative real interest rates. A precondition for such a tightening is a relaxation of exchange rate targeting. Monetary tightening is less obviously necessary in high-income countries, though the US Federal Reserve may have cut too far.
As important is letting the jumps in energy prices pass through, so forcing the needed adjustments in energy use. The beneficiaries of the subsidies offered by many emerging countries are overwhelmingly in upper-income groups. In India, the cost of fuel subsidies is now almost as large as public spending on education: this is scandalous. No less important, however, is abandonment of the silly idea that price jumps in oil or food are the result of wicked "speculation" - a fantasy promoted by dangerous populists across the globe.
Finally, it is essential for the rich countries to cushion the poorest people and countries against such shocks. The aim should be to reduce the pain and to finance necessary adjustment, but not prevent it.
In the medium to long term, the biggest priority is to release energy constraints on growth. This means increased public and private investment in energy research, particularly in renewables. The challenge is huge, but must be met.
The shocks are large. But the more significant one is the high price of energy. The financial crisis was an avoidable stupidity. Rising prices of energy are a bitter reality. The world must adjust to this unpleasant new threat. Ideally, countries would act together. But whether they act together or not, they must act. Otherwise, greater danger - even a bad dose of stagflation - lies ahead.
.........................................
The place to start is with the world economy as a unit. The more globalised economies become, the more appropriate it is to think of the world economy in this way. So what have we learnt about the world economy as a whole? The answer is that it is running into limits on resources, at least in the short term.
Our civilisation is based on fossil fuel. But since the end of 2001, the real price of oil has risen some six-fold. Today, the real price is higher than since the beginning of the previous century. As the World Bank (WB) notes in its Global Development Finance 2008, global oil supply stagnated in 2007. This, argues the report, "contributed to the large decline in stocks in the second half of 2007 and to sharply higher prices". These increases may prove temporary, as happened after the spikes of the 1970s, or permanent. We do not yet know.
Jumps in energy prices have at least three effects on the economy.
First, they increase headline inflation. In emerging economies, above all, bad inflationary surprises have become the norm.
Second, they lower potential supply, by squeezing profits in energy-consuming activities, forcing businesses to scrap energy-intensive capacity, and making it necessary to invest in new and more energy-efficient capacity.
In its latest Economic Outlook, the Organisation for Economic Co-operation and Development (OECD) discusses the consequences of such a negative supply shock on member countries. It makes two large points: first, uncertainty about current levels and future growth of potential output has risen; and, second, the adverse effects of this may be sizeable.
The OECD estimates that the recent rise in the relative real price of oil has lowered steady-state output by 4.0 per cent in the US and 2.0 per cent in the eurozone and lowered potential growth, in the medium term, by 0.2 percentage points and 0.1 percentage points, respectively. This is not trivial: in the case of the US, the decline in the growth of potential output must be at least 10 per cent of potential growth in output per head. In the more advanced emerging economies - and particularly a fast-growing industrialising economy like China - the reduction in the potential rate of growth may well be greater still.
Third, energy price jumps alter the level and distribution of global demand. The move from a price of close to $53 a barrel at the beginning of 2007 to $136 now, increases the annual cost to consumers by around $2,600bn annually, which is a tax of about 4.5 per cent on global non-oil output. Some two-thirds of this transfer is from oil-importing to oil-exporting countries. It is also from those who spend to those inclined to save, at least in the short term.
This shift itself will curb the rise in global demand. So, too, will the financial crises in the US and other high-income countries and the closely related collapse of several huge house-price bubbles. In the high-income countries, growth is forecast by the OECD to slow to a little below trend this year and next. As one would expect, the biggest decline is in the US, with gross domestic product (GDP) growth of 1.2 per cent this year, almost all of which is expected to be contributed by the rise in net exports. From being a locomotive of growth, the US has become dependent on growth elsewhere.
Yet will this decline in the rate of growth in the high-income countries cool an overheated world economy sufficiently? Perhaps not. The OECD expects a decline in growth outside the OECD, but to levels still above (a hard to measure) potential. The World Bank's Global Development Finance does expect a marked decline in developing country growth, though to still high levels, from 7.8 per cent in 2007 to 6.5 per cent this year and 6.4 per cent in 2009. Chinese growth is forecast to slow from 11.9 per cent in 2007 to 9.4 per cent in 2008 and India's from 8.7 per cent to 7.0 per cent.
Yet, as I argued last week, global monetary policy is probably too loose, despite the adverse impact of the credit crisis on high-income countries. In many emerging countries output is growing quickly, with inflation rising strongly. If, as seems likely, the world economy cannot grow as fast as people hoped only a year or two ago, emerging economies have to be part of the adjustment. This will become still more obvious when, at last, the high-income countries recover fully.
Against this difficult background, what are the right responses and how should they be distributed, across the globe? These need to be divided into the short term and the longer term.
In the short term, the biggest monetary policy requirement is a tightening in emerging economies, many of which now have strongly negative real interest rates. A precondition for such a tightening is a relaxation of exchange rate targeting. Monetary tightening is less obviously necessary in high-income countries, though the US Federal Reserve may have cut too far.
As important is letting the jumps in energy prices pass through, so forcing the needed adjustments in energy use. The beneficiaries of the subsidies offered by many emerging countries are overwhelmingly in upper-income groups. In India, the cost of fuel subsidies is now almost as large as public spending on education: this is scandalous. No less important, however, is abandonment of the silly idea that price jumps in oil or food are the result of wicked "speculation" - a fantasy promoted by dangerous populists across the globe.
Finally, it is essential for the rich countries to cushion the poorest people and countries against such shocks. The aim should be to reduce the pain and to finance necessary adjustment, but not prevent it.
In the medium to long term, the biggest priority is to release energy constraints on growth. This means increased public and private investment in energy research, particularly in renewables. The challenge is huge, but must be met.
The shocks are large. But the more significant one is the high price of energy. The financial crisis was an avoidable stupidity. Rising prices of energy are a bitter reality. The world must adjust to this unpleasant new threat. Ideally, countries would act together. But whether they act together or not, they must act. Otherwise, greater danger - even a bad dose of stagflation - lies ahead.
.........................................