How Does the State of Major Economies Affect Us?

Listener: 5 August, 1995.

Keywords: Macroeconomics & Money;

The world economy is not in robust state. Some of leading commentators are muttering about the fragility of the Japanese economy and stagnation in the US one. There is usually one major economy which is worrying, but my concerns here are more about the fundamentals, most notably the very high world real interest rates.

In the 1980s world real interest rates rose by about 5 percentage points. Today the world economy is growing at 3 to 4 percent a year, facing real interest rates above that growth rate. In such circumstances the investment is not profitable, and gets deferred threatening long run stagnation.

A short term measure is to squeeze wages. In most countries real wages have not risen, or have fallen, over the last decade. It is possible for rapid technological change – perhaps like that in the information technology revolution – to support high interest rates for a period, but a high rate of innovation does not go on forever.

Eventually the financiers turn to property and financial speculation where capital gains can cover high interest rates in the short run. In the long run the gains reverse into losses and there is a financial crash, as occurred in 1987. Fortunately buying by Japanese investors underpinned the American financial markets so the bust was not as catastrophic as it could have been. This may well have been one of the great turning points in world history, for suppose there had been a major financial collapse in America, rather than the uncomfortable but limited fall that actually happened. Would the Berlin Wall have fallen? Would the second world of Russia and its empire have disintegrated so quickly?

It may well have been a closer run than it seemed even at the time. It was thought then that the Japanese financial markets were not totally sound, subject to a similar overvaluation of assets and excessive gearing of debt that American (and, to a far greater extent, Australasian) financial markets suffered in 1987. But because they retained confidence, supported by an accommodating Japanese Reserve Bank, Japanese financiers were able to buy stocks and shares in the US, steadying the collapse. It now seems that the Japanese financial markets were in a worse state than the American ones. Recently the Japanese monetary authorities have been trying to correct the imbalances by a steady squeeze, but their productive economy is suffering as a result too.

Suppose something were to go desperately wrong in Japan. Would the Americans be able to bale them out, returning the 1987 favour? The answer is only “perhaps”, for there is a serious structural problem which the US economy faces, and which causes high real interest rates. Since Reagan’s tax cuts of the 1980s, the US government has been running an unsustainable budget deficit. The largest economy in the world has had a savings deficit, and the scramble for the reduced volume of savings pushed up world interest rates. So severe has been this deficit, that the world’s largest creditor nation at the beginning of the Reagan era became, eight years later, the world’s largest debtor nation by its end.

As much as one may worry when a small economy such as New Zealand runs unsustainable budget deficits year after year, it is a couple of magnitudes worse if the largest economy in the world does this. The US is the banker to the world, with the US dollar as the currency of the world. In the short run that makes it easy for the US to run a huge deficit, for it can finance it by issuing its own currency. In the long run no one can be happy with a banker whose finances are in such disarray, unable to take measures to address them, except with promises to do so in a decade or so. If the Japanese financial markets crash, then the banker of the world is not well placed to bail the it out. It may not be able to.

This is all very speculative. I dont wake up each morning wondering whether the Tokyo financial markets went down over night, any more than a seismologist asks whether there was an earthquake there. But neither of us will be surprised if our worse fears happen, and are grateful they have not happened yet.

Nor need the collapse, if it does happen, occur in a predictable mechanical way. One possible scenario is hyper-inflation which reduces the value of the dollars that Reagan and his successors have unloaded on the world. Another is depression.

Whatever happens after a crash, New Zealand could suffer badly from any international fallout. That is one reason why I support the running of a budget surplus here. An internal surplus and reduced public debt gives us more room to move. But I am becoming increasingly worried about our large balance of payments deficit, which is being covered by overseas borrowing overseas. The private sector (you and me) is not saving enough. The external deficit presents a national danger even if the world economy remains stable. That danger belongs to another column.