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Global Trends and Economic Security 2014 CCMR Executive Course in Decision Making Naval Postgraduate School October 21, 2014 Dr. Robert E. Looney [email protected] Outline • The Global Economic Crisis and Aftermath • Patterns of Recovery • The Current Situation • What Markets are Saying in October 2014 • Implications for the Future • Forecasts • • Risks, Concerns, and Scenarios Key Risks • Emerging Economies -- Slowdown • Eurozone Crisis -- Stagnation • Asian Tensions – Increased defense expenditures • China Hard Landing – Instability in the global economy • Backlash Against Globalization – Increasing nationalism • • Falling Defense Expenditures in the West – Declining world security General Lessons 2 The Global Crisis 3 Economic Crisis and Security Threats “The global recession is America’s primary near-term security concern.” Admiral Blair – Director of National Intelligence (February 2009) “The single biggest threat to national security is the national debt.” Admiral Mullen, Chairman of the Joint Chiefs of Staff (August 2010) “I have to confess, I paid no attention to this (economics) as a cadet and have done nothing to increase my awareness of economics issues between age 22 and 59. I should have paid attention.” General Dempsey, Chairman of the Joint Chiefs of Staff (October 2011) 4 Global Economy Overview I • Before the 2008-09 crisis, the main feature of the global economy was its rapid integration – has continued at a slower pace since the crisis • Trade relative to GDP, capital flows relative to the global capital stock and so on are all rising • However, economic policies largely set at the national level to benefit domestic economy • These policies are increasingly affecting other economies • External effects are particularly important in the financial sector due to potential for large and abrupt changes in: • Capital flows • Asset prices • Interest rates, exchange rates, and • Credit availability. 5 Global Economy Overview II • The 2008-09 global economic crisis and its aftermath illustrate this new reality • Characterized by defective growth models in advanced economies based on • Excess monetary expansion/credit and • Debt-driven domestic aggregate demand • Complicated by structural flaws and limited adjustment mechanisms in Europe leading to • Instability • An on-going crisis • Large negative shock to the real economy • Emerging economies were subsequently affected by • Credit tightening (including trade finance) • Rapid declines in exports 6 Global Economy Overview III • Post-crisis policy largely based on credit expansion and debt reduction • Unconventional monetary policy – United States • Lowered cost of credit for debtors and those seeking to borrow for business expansion • Came at the at expense of savers – lower interest rates • Did not work well because investment constrained by deficient domestic demand relative to capacity • Savers sought higher returns in emerging economies • Causing increases in credit and causing upward pressure on exchange rates and asset prices – Emerging economies responded with • Limits on capital inflows • Reserve accumulation and • Measures to restrict credit and restrain asset-price inflation 7 Global Economy Overview IV • Situation changed in May 2013 when U.S. Federal reserve indicated it might taper its purchase of long-term assets • Asset prices shifted and in emerging economies • Capital rushed out, • Caused credit markets to tighten and • Exchange rates to fall • Causing a slowdown in short-term growth. • The reversals may have longer term adverse effects – although not clear at this point • While China’s output is affected by advanced country economic performance – financial system largely isolated • Capital account less open, foreign currency reserves of $2.5 trillion mean exchange rate is controllable 8 Global Economy Overview V • Decentralized policy and growing externalities will result in a partial de-globalization • Not a good idea to run persistent current account deficits and become dependent on (temporarily) low-cost foreign capital • Open capital accounts may be replaced by rules-based constraints on financial capital flows • Lesson from crisis • Pattern of accumulating reserves via current account surplus will be more pronounced in order to manage exchange rates • Public purchases of domestic assets to stabilize asset prices net capital flows will become increasingly common. • Successful countries will be those who learn to live with growing policy interdependency without much policy coordination 9 Crisis Has Accelerated Changes in World GDP 10 Decline of the G-8 11 Patterns of Future Pubic Debt 12 Debt Vulnerability 13 Industrial Recovery 14 Current Global Situation I • Six years after the 2008-09 crisis, economic performance still disappoints, failing to regain pre-crisis vitality • Emerging economies far from the dynamic miracles they once seemed • Rich countries still grappling with problems exposed by the crisis • Return to days of buoyant growth seems far away • Level of dissatisfaction summed up at September 2014 G20 meeting – their summary statement: • “Growth in the global economy is uneven and remains below the pace required to adequately generate much needed jobs.” • Worse -- they saw new threats in financial markets and deteriorating geopolitics • Little unity among the member countries who account for 85% of world output 15 Current Global Situation II 16 Current Global Situation III 17 Current Global Situation IV • Although the global picture is disappointing there are signs of optimism along with underperformance: • The growth surge in the in the UK along side economic weakness in France • Recent optimism in India together with the disappointing performance of Russia and Brazil exposing their weaknesses. • Across the world recovery can not be easily characterized as V-shaped or L-shaped • Instead OECD feels there is a “growing degree of divergence between the major economies” • U.S. economy appears to be expanding at a moderate pace with unemployment falling • U.K and Canada are also growing above their normal rates of expansion 18 Current Global Situation V • Most of the current concern is with the Eurozone. • With inflation falling close to zero, demand in the region • Appears insufficient to bring down an 11.5% unemployment rate • May not prevent bloc from sliding into deflation • The loss in economic momentum may • Dampen private investment and • Heightened geopolitical risks – populist governments that have a further negative impact on business and consumer confidence. • In Japan early optimism over Abenomics – economic policies of the prime-minister is now • Tempered with the fear that rising taxes are a major drag on growth • Facing the need for major, but politically unpopular structural reforms – resulting in questions over whether Japan would continue on its path 19 Current Global Situation VI • In today’s global economy • No longer the advanced world that is most important for global trends • Fully 30 percent of global growth in 2014 will occur in China – about twice the share of the U.S. • Clearly the success of China’s economy is now vital for the rest of the world. However there are problems. • For the medium-term, there is not much evidence that the Chinese economy has made much progress in its critical rebalancing efforts • In the short-term, are fears of a housing crash and bank failures • Housing prices have dropped 9.3% over the last year with • Sales registering the deepest contraction since 2008 • Moody’s estimates that a 10% fall in both property transactions and prices would reduce growth by 1.5% to 2% bringing it to 5 or 6% 20 Current Global Situation VII • At October 2014 Conference, even the IMF showing increased pessimism • The IMF feels there are many emerging concerns: • Geopolitical tensions from the Middle East and Russia could • “trigger large spillovers of activity in other parts of the world through a renewed bout of increased risk aversion in global financial markets.” • The Fund has just downgraded many of their forecasts • Big question is why countries are struggling to sustain decent rates of growth • Much has to do with remaining hangover from the financial crisis. 21 Current Global Situation VIII • Factors continuing to limit the return to growth and job creation • • • • • High levels of public and private debt act as constraints on • Government fiscal policy and • Consumer spending • Work to suppress aggregate demand below levels needed for steady growth Increased income inequality also tends to reduce consumer spending Policy uncertainty in many countries has resulted in falling investment rates Slowing world economy makes export-led growth more difficult Situation made worse by signs that productivity growth is slowing, limiting the potential for sustainable growth revival 22 Current Global Situation IX 23 Current Global Situation IX 24 Current Global Situation IX • In the emerging economies • Growth has slowed from 7% per year before the crisis • To a forecast of 5% between 2014 and 2018 • Moreover the decline is not just due to the slowdown in China and India • Growth rates are now lower than pre-crisis average in 70% of emerging economies. • The slowdown in emerging economies is due to: • The prolonged weakness of high income economies, • Failure to sustain economic reforms and • The exhaustion of policy induced post-crisis boosts to domestic demand. 25 Current Global Situation X • Policy makers are in a bind in many countries • In the Eurozone and Japan they are still trying to find ways to stimulate demand • In the U.S. and U.K interest rates are about to increase, but there is widespread concern that any movement back to normal might trigger financial turmoil • However leaving monetary policy loose will encourage excessive borrowing which may create bubbles and another financial crash • In emerging markets the need is to push forward on structural reforms to labor and product markets as well as education and social security to enable more secure and rapid growth • Not easy and mistakes are certain to happen. • The economic environment in many parts of the world is thus quite fragile with forecasts increasingly pessimistic. 26 October 2014 Markets Sending Bad Signals: I Worrying signals from the markets – October 2014 • When economic outlook becomes gloomy, investors buy government bonds of nations viewed as secure • When the economic outlook appears to worsen, investors assume central banks will keep interest rates low • Follows that government bond yields of advanced countries works as a convenient proxy for whether economic expectations are becoming more or worse pessimistic • Inflation – can gauge how much investors in the bond market expect prices to rise in the years ahead based on the difference in prices between regular bonds and those indexed to inflation • Last few months point to a sharp drop in inflationary expectations – powerful forces pulling prices down around the world 27 October 2014 Markets Sending Bad Signals: II 28 October 2014 Markets Sending Bad Signals: III 29 October 2014 Markets Sending Bad Signals: IV • Commodity prices – declining sharply • Crude oil down $22 barrel or 22% since June 30 • Corn futures down 31% since end of April • Currency – value of dollar • Primarily shaped by shifts in interest rates, economic growth and inflation rates in various countries • Dollar has been rising sharply against most other currencies since summer – during a period where prices and inflation expectations have been falling worldwide • Dollar’s rise has been steepest against currencies in places where the domestic economic outlook is worse, 30 October 2014 Markets Sending Bad Signals: V 31 October 2014 Markets Sending Bad Signals: VI 32 October 2014 Markets Sending Bad Signals: VII Adding it up: • Markets aren’t anticipating on a catastrophe yet • If they were stock prices would be down more • They are betting that central banks and other policy makers aren’t going to be able to control global deflationary forces • Means world economy could be in for a slow grind in which both global growth and inflation both stay below normal levels • Situation much better than fall of 2008, but much worse that it should be six years after a crisis. 33 China: Signs of Economic Slowdown 34 Implications for the Future • The slowdown will mean • Weaker growth in world trade • Lower commodity prices and • The possibility of unexpected losses in the financial sector • Increasing burdens on debtors • With growth in high income economies constrained by inadequate domestic demand, a risk of feedback effects exist • The channels go from • slowing emerging economies to • high income economies especially the more export dependent ones and • back again 35 IMF Forecasts: October 2014: I 36 IMF Forecasts: October 2014: II 37 IMF Forecasts: October 2014: III 38 Risks and Concerns I • IMF October 2014 Message • Risks have increased: • Uneven Fragile growth • Risks from protracted low inflation • Financial sector excesses • Simmering geopolitical tensions • Emerging markets slowing • Surprises in monetary policy normalization 39 Risks and Concerns II Other Assessments Conclude: • Tail Risks (probability of occurrence less than 10%) Include: • “Positive” outcome of bubbles is possible in 2014-15 • Hard landing in China • Disorderly events in EZ (more likely to be a long stagnation or deflation as in Japan post 1990) • EM political risks amid numerous elections • Geopolitical risks include: North Korea, China-Japan, Egypt, Syria, Iraq and Iran (despite improved international relations/nuclear deal). • Longer-Run Trends Pose Policy Challenges • Falling productivity • Increased inequality 40 Scenarios to 2018 41 Assessment of Key Risks • The current consensus forecasts and scenarios are sensitive to a series of possible shocks/adverse developments. • Adverse developments in one or more areas might result in increased instability and/or negative linkages leading to lower growth rates: 1. Emerging Economies Slowdown 2. Eurozone Crisis -Stagnation 3. China Hard Landing 4. Backlash Against Globalization 5. Asian Tensions 6. Declining Defense Expenditures in the West 42 Key Risk I: EM Slowdown I • Range of factors will confront the emerging economies • Weak financing, currency overvaluation or policy missteps will likely have major negative impacts on many • Considerable differentiation in the emerging world. For some: • A policy-induced slowdown after some overheating: Many Ems tightened monetary policy in 2011 • A lack of full decoupling from hobbled DMs (EZ) • State capitalism is now distorting economic activity and leading to a fall in potential growth • A fallout from the Chinese slowdown: China is negatively affecting growth across Ems (especially in Southeast Asia, Latin America, metals exporters • The end of the commodities supercycle. 43 Key Risk I: EM Slowdown II • The end of QE and easy money: Will slow, in for reverse, trillions in EM capital flows • Increasing frequency of large current account deficits: many financed in ever-riskier ways • Rising political risk in many EMs: Busy electoral cycle in 2014 including Brazil, Turkey and South Africa • Macro and financial fragilities in some EMs: A handful of EMs have high and unsustainable debt ratios that will require coercive debt restructurings, particularly if a sudden stop occurs • The risk of a middle income trap: Many running out of easy sources of growth • In the case of Asia, exports have failed to maintain sustained growth as they did after previous economic 44 crises. Key Risk I: EM Slowdown III 45 Asian Export Slowdown 46 Key Risk II: Eurozone Crisis I • • • • • • The current crisis in the Euro-zone can be easily traced back to a fundamental flaw in the Zone’s economic model: The model concentrated monetary policy in the European Central Bank (ECB) while leaving fiscal policy to individual member states – inherently unstable arrangement It denies member states monetary policy levers with which to help their recoveries Also makes deficit-funded stimulus harder as monetary policy can be used to keep borrowing costs low. The EZ is not an optimal currency area – the common monetary authority is likely to act in ways that help some countries but not others. • The ECB has pursued tight monetary policy that may prevent inflation in highgrowth states like Germany but could also be worsening the recession in Greece, Spain and other struggling states. • Rigid labor markets prevent adjustments common in the United States. Also Europe still lacks key elements necessary for a common currency to work – Joint European Bank Regulator and a system for dealing with troubled financial institutions, unconstrained independent, central bank 47 Key Risk II: Eurozone Crisis II • In Europe much of current stability is due to • The pledge of the European Central Bank (ECB) to defend the euro “at any cost” • New financial instruments to defuse debt, and • The start of a banking union • However fiscal adjustment remains unsupportive; unemployment is high in the core economies and continues to increase in Southern Europe • The ECB is under increasing pressures to move toward US-style large-scale bond purchases – controversial whether this will make any difference • At the national level, many of the troubled countries have the option of cutting spending or not cutting – both with major downsides. 48 Key Risk II: Eurozone Crisis III 49 Key Risk II: Eurozone Crisis IV 50 Debt 01-2015 51 Key Risk II: Eurozone Crisis V 1. Cut spending – pretty sure to deepen the recession • Probably means more unemployment (already well over 20% in Spain) • May push wages down to more competitive levels – history suggests this is very hard to do. • Even so, lower wages will just make people’s debts even harder to repay • Meaning they are likely to cut their own spending even more, or stop repaying their debts • Lower wages may not even lead to a quick rise in exports if other European economies markets are in a recession too • In any case, can probably expect more strikes and protests and more nervousness in financial markets (causing even higher interest rates) about whether 52 you really will stay in the euro Key Risk II: Eurozone Crisis VI 2. Don’t cut spending • Risks a financial collapse • Amount borrowed each year has exploded since 2008 due to economic stagnation and high unemployment • But if economies are chronically uncompetitive within the euro • Markets liable to lose confidence in you – may fear that economies simply too weak to support increasing debt load • Meanwhile other European governments may not have enough money to bail you out, or are legally/politically constrained from doing so • European central bank has said its mandate doesn’t allow it to provide unlimited bond purchases • Clearly only way out of crisis is a coordinated approach involving creditors and debtors and international institutions such as the IMF 53 Key Risk II: Eurozone Crisis VII 54 Key Risk II: Eurozone Crisis VIII • Europe: Defense Spending by Country 55 Key Risk II: Eurozone Crisis IX 56 Key Risk III: Asian Tensions I • Asia – Escalating Friction • Ukraine crisis is far from Asia, but the region is coping with geopolitical risks of its own • Since last fall tension increased in East and Southeast China Sea among • Japan, China, South Korea, Philippines, Vietnam. and Other Southeast Asian counties • The friction is long-standing, but it has escalated since 2009 when President Obama initiated the U.S. pivot to Asia • Reinforced Chinese rebalancing in the region • S&Poors: • While economic growth should be strong, any major incident could cause significant damage and a substantial spillover to sovereign creditworthiness in Asia Pacific 57 Key Risks III: Asian Tensions II • Asia: Total Defense Spending by Country 58 Key Risk IV: China Hard Landing I Overview: • China’s economy is currently going through a painful transition to a more consumption based economy • The days of double digit economic growth clearly over • In the short run, slower growth is generating concern about the nation’s near-and medium-term prospects • There is an up-side to the gradual slowdown over the past several years • Growth in the coming years will be both robust and more sustainable • The structural reforms that are central to the 12th Five Year Plan (20112015) will become somewhat easier to achieve • On balance it appears China’s economy is headed in the right direction, but still worrisome in the short-run • However, key economic and political risks – including corruption, social inequality and lack of progress in governance reforms – must be addressed in order to assure 59 long-term economic growth. Key Risk IV: China Hard Landing II 60 Key Risk IV: China Hard Landing III • • China’s economic adjustment after the 2008 crisis has been impressive but risks may have intensified. These include: • Corruption and social inequality • The possibility of financial instability due to the proliferation of many new, poorly supervised financial products as well as increased corporate leverage • Falling profit margins which have lowered business confidence • Though the housing market in big cities seems to have stabilized a large stock of vacant apartments continues to weigh on prices Widely reported over investment in basic infrastructure will by contrast probably turn out to be less of a problem than overinvestment in manufacturing and high end real estate • • • Most of the new infrastructure has been created ahead of needs as part of the government’s strategy to stimulate new development opportunities. Greatest risk facing China today is stagnant political reform, including promotion of the rule of law Without progress on this front, social inequality, and perceived unfairness could jeopardize the transition to the next stage of development and with it the country’s long term economic prospects. 61 Key Risk IV: China Hard Landing IV • The risk of a sharp slowdown in China remains elevated and will rise in the medium term as: • Financial liberalization contends with • Legacy debts from unproductive local government investments and excess residential real estate construction • Scenarios in two stages. Outcomes at the intermediate stage can lead to any of the longer-term scenarios with various probabilities 62 Key Risk IV: China Hard Landing V 63 Key Risk V: Backlash Against Globalization I • In the aftermath of the 2009 global financial crisis • Policymakers success in preventing the Great Recession from Turning into the Great Depression II held in check demands for protectionist and inward-looking measures • Now the backlash against globalization – and the freer movement of goods, services, capital, labor and technology has arrived • New nationalism takes different economic forms: • Trade barriers • Reaction against foreign direct investment • Policies favoring domestic workers and firms, • Anti-immigration measures, • State capitalism, and • Resource nationalism 64 Key Risk V: Backlash Against Globalization II • These forces are hostile to international organizations that globalization requires: • The European Union (EU), • The United Nations (UN), • The World Trade Organization (WTO), and • International Monetary Fund (IMF) • Even the internet at risk in more authorities countries – China, Iran, Turkey and Russia as they seek to restrict access to social media and crack down on free expression. 65 Key Risk V: Backlash Against Globalization III • The main causes of these trends are clear: • Anemic economic recovery has provided an opening for populist parties, promoting protectionist policies, to blame foreign trade and foreign workers for the protracted malaise. • Rise in income and wealth inequality in most countries creates the perception of a winner-take-all economy that benefits only elites has become widespread. • Powerful groups perceived in control – in advanced economies (where unlimited financing of elected officials by interest groups) and emerging markets (where oligarchs often dominate the economy and the political system). 66 Key Risk V: Backlash Against Globalization IV • Secular stagnation for many with depressed employment and stagnating wages. • Resulting economic insecurity for the working and middle classes is most acute in Europe and the Eurozone • As in the 1930s when the Great Depression gave rise to authoritarian governments in Italy, Germany and Spain, a similar trend may now be underway • If income and job growth do not pick up soon, populist parties may come closer to power at the national level in Europe, with anti-EU sentiments stalling the process of European economic and political integration. • Worse the Eurozone may again be at risk: some countries (the UK) may exit; others (the U.K., Spain and Belgium eventually may break up. 67 Key Risk V: Backlash Against Globalization V • • In the U.S. economic insecurity across a vast share of the population has resulted in feelings of threat from immigration and global trade. • These groups are characterized by economic nativism, antiimmigration, protectionist leanings and geopolitical isolation. Variant of this dynamic can be seen in Russia, many parts of Eastern Europe and Central Asia where the fall of the Berlin Wall did not usher in • Democracy • Economic liberalization and • • Rapid output growth Instead, nationalist and authoritarian regimes have been in power for most of the past quarter century • Pursuing state-capitalist growth models that ensure only mediocre economic performance. • Putin’s dream of a Eurasian Union – destabilization of the Ukraine 68 to recreate the former Soviet Union. Key Risk V: Backlash Against Globalization VI • In Asia, too nationalism is resurgent • New leaders in China, Japan, South Korea and now India are political nationalists in regions where territorial disputes remain serious and long-held grievances fester • These leaders as well as those in Thailand, and Malaysia who are moving in a similar nationalist direction and must: • address major structural-reform challenges if they are to revive failing economic growth and • In the case of emerging markets, avoid a middle income trap. • Economic failure could fuel further nationalist, xenophobic tendencies – and even trigger military conflict 69 Key Risk V: Backlash Against Globalization VII • The Middle East remains a region mired in backwardness. • The Arab Spring – triggered by slow growth, high youth unemployment and widespread economic desperation has given way to a long winter in Egypt and Libya where alternatives are a return to authoritarian strongmen and political chaos. • In Syria and Yemen there is civil war. • Lebanon and Iraq – ongoing instability • Iran is both unstable and dangerous to others, and • In all these cases economic failure and a lack of opportunities and hope for the poor and young are fueling political extremism, resentment of the west and in some cases outright terrorism 70 Key Risk V: Backlash Against Globalization VIII • In the 1930s the failure to prevent the Great Depression empowered authoritarian regimes in Europe and Asia eventually leading to the Second World War. • This time, the damage caused by the Great Recession is subjecting most advanced economies to secular stagnation and creating major structural growth challenges for emerging markets • Ideal terrain for economic and political nationalism to take root and flourish • Today’s backlash against trade and globalization should be viewed in the context of what as we know from experience could come next. 71 Key Risk VI: Falling Defense Expenditures I • Military expenditures are only one gauge of military power. • A given financial commitment may be adequate or inadequate depending on: • The number and capability of a nation’s adversaries • How well a country invests its funds and • What it seeks to accomplish • Nevertheless trends in military spending do reveal something about a country’s capacity for meeting threats • Policymakers are currently debating the appropriate level of US military spending given: • increasingly constrained budgets • the winding down of involvement in Afghanistan and • the potential threats posed by Russia and China 72 Key Risk VI: Falling Defense Expenditures II 73 Key Risk VI: Falling Defense Expenditures III 74 Key Risk VI: Falling Defense Expenditures IV 75 Key Risk VI: Falling Defense Expenditures V 76 Key Risk VI: Falling Defense Expenditures VI 77 Key Risk VI: Falling Defense Expenditures VII • Although there are a few exceptions there is a stinking contrast between rising defense expenditures in still growing economies and austerity-induced cutbacks elsewhere • Robust growth in emerging world means that these countries can increasingly afford to procure cutting edge defense technologies • Increased military spending is a zero sum game and will inevitably generate arms races • Certain countries – China, India, and Russia take the view that their economic growth should be matched by equally impressive developments in their military capabilities. • U.S. and European allies risk falling behind on defense expenditures unless they can revive growth and better 78 control social expenditures. General Lessons • Nobody Really Understands the World Economy – economic outcomes hard to predict because world economy is continually in flux – “unknown unknowns” will always be with us. • That Goes Double for Financial Markets – financial markets even more volatile than real economy – Starting with the Dutch Tulip Bubble have had 350 years of financial crashes and panics – unlikely to stop anytime soon – each one that comes will take most people by surprise. • The Battle of Financial Markets is Over: The Battle of State Finance Has Begun – Speculators will test sovereign debt markets. Clear that governments can no longer do whatever it takes to fix economic problems. New, large and unpredictable risks now hang over the global economy. • The US and its allies will face a long period of slow growth with contracting defense budets. This will require increased cooperation, coordination, and flexibility in adapting to a 79 fundamentally altered budgetary environment The End • Questions? 80