Lessons from the Global Slowdown

It’s official: the world is in a global slowdown: maybe not a recession, but certainly a slowdown. Growth in 2001 is expected to be half of last year’s. Japan seems headed for a real recession, and Europe’s bragging that its strong fundamentals will allow it to weather the American slowdown with hardly a dent on its growth seems to be without foundation.

As the world sinks into slowdown, several policy lessons emerge. Some are more obvious than others; each devastates the conventional wisdom of but a short while ago (a salutary reminder, perhaps, of the precariousness of our knowledge).

Slowdown has cast a pallor over the Clinton Administration’s boasting, its promise that if a country adhered to capitalism American-style then it would be assured of unprecedented and sustained prosperity. It now appears, however, that some of the boom of the last years of the 1990s was as much a mirage as the collapsed boom of East Asia.

In each case, irrational market exuberance fed excessive investment which led to excess capacity. In retrospect, the best that can be said of former US Treasury Secretary Robert Rubin and current Fed Chairman Alan Greenspan is that they enjoyed the ride while the going was good, and Rubin was smart enough to bail out before the crash. Each, however, can also be said to be guilty of dangerous driving.

Once, the “New Economy” was thought to mean the end of the business cycle. With “just-in-time” production that entailed smaller inventories, new information systems that allowed for better control of inventories, and the decline in manufacturing, inventory cycles seemed a thing of the past. But economic fluctuations have marked capitalism since its origins, and inventory cycles are only one source of fluctuation.

The 1997-98 global crises were merely the most recent manifestation of the financial crises that have plagued capitalism forever — and capital and financial market liberalization combined with globalized capital markets have, if anything, created increased vulnerability, especially in small countries. Real estate bubbles are another fact of life; and when they bust, as they did in the 1980s in the US, Scandinavia, and Thailand, they bring down economies with them.

What is clear is that the claim of market fundamentalists that markets are self-adjusting is wrong. There is an important role for government in macroeconomic stabilization. The question is, what is that role?

The tendency to fight the last war, sadly, is true for economic policy makers as well as generals. The oil crises of 1973 led to a decade or more of inflation, and the scars are still being felt. Worry about inflation led the Fed to increase interest rates in late 2000, when the impending slowdown required the opposite medicine.

With two of the world’s largest economies facing sustained deflation in the last few years, and inflation contained almost everywhere, the focus should not be inflation, but rather unemployment and underutilization of economic capacity. Potential losses from this are far greater than those associated with the slight increases in inflation that a more aggressive macroeconomic policy might entail. Indeed, statistical studies find virtually no evidence of significant adverse effects of increases in inflation, so long as it remains low to moderate.

Today’s systematic lack of aggregate demand is a cause for worry. Several of the world’s countries seem determined to maintain large trade surpluses. There is a basic law in economics: the sum of the trade surpluses and deficits must add up to zero. If some country has a surplus, another country must have a deficit.

But the IMF is telling everyone not to have a deficit. Someone, however, must run a deficit, if others run a surplus. Deficits are like hot potatoes, passed from one country to another. A country with too large a deficit faces a crisis and soon switches policy to secure a surplus: that is what has happened in East Asia. The deficit does not disappear; it just moves on.

Fortunately, one country has been willing and able to run large trade deficits — the United States. It is now no longer clear how long this can continue without a loss of confidence. It may be difficult to predict the trigger — the impending fiscal deficits resulting from President Bush’s tax cut could do trick. When that happens, more than a global economic slowdown might result.

The problems of insufficient global aggregate demand were on the minds of John Maynard Keynes and others who conceived and founded the IMF. There is a framework for enhancing aggregate purchasing power, through the creation of SDRs (special drawing rights —Ed.). One way of thinking about this is the following: assume that the nations of the world wish to maintain reserves equal to a fixed percentage of their GDP. With global GDP of around $40 trillion, and growth of around 2%, if reserves were equal to 5% of GDP, aggregate reserves would grow by $40 billion a year.

Given China’s and Japan’s surpluses, a number twice that size might be more realistic. An annual issue of SDRs in that amount would offset the purchasing power set aside in currency reserves and would thus not be inflationary. These SDRs could be used to pursue global interests — from helping poor countries to improving the global environment.

For the past several decades, the IMF has focused on bailing out creditors and pushing the neo-liberal agenda. The time is ripe for the IMF to return to its original mission — ensuring global liquidity to enable sustained global growth.

Joseph STIGLITZ , Nobel prize laureate in economics 2001 and professor of economics at Columbia University, was formerly Chairman of the Council of Economic Advisers to US President William J. Clinton and Chief Economist and Senior Vice President of the World Bank