Can the Global Economy Avoid a Crisis?

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Hal Weitzman: With slowing economic growth in China, interest rates rising in the US, and the commodity slump hitting producer countries, there are plenty of reasons to be worried about the global economy—not to mention mass migration, war, terrorism, and political uncertainty.

Global economic growth is going to be disappointing and patchy in 2016, according to the IMF, and prospects for the medium term are worsening, with persistent low productivity and aging populations.

So is this what secular stagnation looks like? Or is this all far too pessimistic and doom laden? Will we muddle through with modest growth but no big crises?

Welcome to The Big Question, the monthly video series from Capital Ideas at Chicago Booth. I’m Hal Weitzman, and with me to discuss the issue is an expert panel.

Randall Kroszner is the Norman R. Bobins Professor of Economics at Chicago Booth. He was a governor of the Federal Reserve from 2006 to 2009, and a member of President George W. Bush’s Council of Economic Advisers from 2001 to 2003.

Amir Sufi is the Bruce Lindsay Professor of Economics and Public Policy at Chicago Booth. He’s the coauthor of House of Debt: How They (and You) Caused the Great Recession, And How We Can Prevent It from Happening Again.

And James Robinson is a professor at the Harris School of Public Policy at the University of Chicago. He’s the coauthor of the best-selling book, Why Nations Fail: The Origins of Power, Prosperity, and Poverty.

Panel, welcome to The Big Question.

Randy Kroszner, let me start with you. China is what everyone is concerned about at the moment, particularly the financial sector. There were prospects of possible bank failures. How concerned should we be for the global economy about what’s happening in China?

Randall S. Kroszner: Well, I think, with China becoming the world’s second largest economy, of course, it’s much more important than it had been before. It has grown very rapidly. Certainly there have been problems in the banking system in the early part of this century, but they were able to deal with those relatively easily domestically, but now there can be bigger ramifications.

I think the key challenge is, what they’ve done is, by trying to defend the stock market, they’ve dramatically increased the exposure of the entire financial system to the stock market. So when they . . . the turn in the stock market came when they were doing a very sensible macroprudential policy saying there was too much shadow-bank lending to margin finance for people borrowing to buy stocks, that then precipitated the downfall. But, in some sense, that was what they were trying to do, to take some of the air out of the bubble in the stock market.

But what they did in response is they said, uh-oh, this is a problem. So let’s continue to lend, and maybe increase lending. Let’s make sure everybody buys, and not permit people to sell. So now the insurance companies, the banks, the securities firms have much bigger exposure to the stock market than they had before. That makes things a bit more fragile than they’d otherwise been.

Hal Weitzman: And should we be worried about the stock market specifically, or, I mean, what about the general Chinese economy?

Randall S. Kroszner: One would only worry about the stock market to the extent that it causes difficulty for the financial system generally. The stock market moving up and down, that in and of itself is not causing the problems globally, or causing the problems in China. What it is is, if there’s an economic slowdown, and you make the banking system much more fragile, that’s really problematic.

Hal Weitzman: OK, Amir Sufi, what about the Chinese economy? What are the headwinds, what are the factors that concern you?

Amir Sufi: Yeah, I think a lot of people have focused on the banking sector, and obviously, there’s big problems there. McKinsey Global Institute put out a nice report just tracking debt to income ratios in different countries, and if you look at it, unsurprisingly China leads the world in terms of the growth in debt-to-income ratios for the financial sector from 2007 to 2014, which is really when a lot of this boom was happening.

But it also is third when it comes to the expansion in corporate debt and fourth out of 50 countries in terms of household debt–to-income ratios. So more broadly than just the financial sector, China has kind of followed the exact model that we know historically leads to pretty severe economic downturns, and that is: huge increases in debt to finance housing booms, to finance consumer durables. And those typically end very badly, and that’s my fear is that it could end up very badly for China.

Hal Weitzman: It sounds like it, according to your description, sort of has to end in a crisis sooner or later.

Amir Sufi: Yeah, I mean I think the argument at this point in my head is, will China do poorly or terribly? I think that’s kind of the two options I see going.

Hal Weitzman: Can it avoid a sort of hard landing, a real crisis?

Amir Sufi: I think that people point to first, the exception to the rule they say is, well look, China has run current account surpluses. They have large reserves. So unlike Greece, or, you know, even the United States, we weren’t running current account deficits, and so they have capacity to fight against this thing.

And the other thing that people say is, well, China is essentially a planned economy. I’m not particularly convinced by either of those. I think it does help that you’re running current account surpluses and that you have extra reserves at the central bank, but the same was true of Japan in the late 1980s, and it looks a lot like what happened in Japan in terms of the run-up. Big increases in commercial real-estate prices, big increases in the commercial real-estate investments.

So that does lead me to worry that despite the fact that maybe they can shift some resources around, you’re still gonna see a pretty severe economic downturn in China.

Hal Weitzman: OK, Randy Kroszner, that was a somewhat more pessimistic view than yours. You still think they’re gonna be able to muddle through and avoid a crisis in China?

Randall S. Kroszner: Well, I think it depends a lot on the policies. They’ve made things more fragile. I completely agree with what Amir has said that they have a lot of debt, and both in the official sector and in the semiprivate sector. That makes things fragile to begin with.

They’ve dramatically increased the exposure to the equity markets, which you have to remember, there’s a big up and down in the equity markets in China back in 2006 to 2008 that left no imprint, and they made it through the global financial crisis reasonably well.

So the stock market movement up and down doesn’t necessarily have any impact on the real economy or cause the broader financial fragility. It’s this build up of debt in response to try to make it through the global financial crisis in a short-term healthy way that in some sense is a little bit of a ticking time bomb.

I’m not quite as pessimistic as Amir is, but it is something that they’re gonna have to be very careful to deal with. And although they have a lot of reserves, you can blow through those reserves relatively quickly. I mean, at $100 billion a month, which seems to be what they’re doing, even if you have $3 trillion worth of reserves, that doesn’t all that long. And even if it is gonna last a while, once the markets see that you’re gonna start blowing through that, then the markets start really questioning things.

Amir Sufi: Two numbers that I’ve just been looking at that I think are quite scary to me is one, if you look at measure of economic activity like electricity consumption. So it was basically 25 percent year-over-year growth in electricity consumption in 2010. It was 15 percent in 2012, and it was 0 percent in 2015. That’s a pretty worrisome sign.

The other number that just came out at the beginning of January was freight, freight capacity and freight amounts quantities being shipped. And it was actually down year over year, which is the worst reading in its history of being followed in China.

So my view is that whenever you have a situation in which people have built far too many buildings, they’ve bought too many cars, you know, a lot of people have bought houses they can’t afford, that that usually portends bad things. And so that’s why I am probably a little bit more pessimistic—

Hal Weitzman: And one of the reasons for that overcapacity, as you mentioned earlier, is central planning.

James Robinson, let me bring you in. I mean, can China achieve long-term economic growth, sustainable economic growth, if it doesn’t fundamentally reform its political system?

James Robinson: No, I don’t think. I mean, apart from, you know, all of these dynamics that we’ve been talking about here, you know, I would say the bigger problem in the long run for China, you know, whether or not there’s a financial crisis or whatever, is, you know, the businessmen disappearing for a few days, and nobody knows where they are, and then they reappear.

You know, that to me is a sort of fascinating example of just this fundamentally kind of autocratic political system, unreformed autocratic political system that there is in China.

And I would say, you know, you just can’t build a modern, successful, prosperous society when you just have this ridiculous concentration of political power, you know. I think if you look historically, there’s many instances where, you know, if the people at the top decide this is OK, we can push for this, it works for a while. It works for 10 years, or 20 years, or 30 years.

You know when I was an undergraduate, we learned that, you know, the Soviet Union was the economic model to follow, you know, and that’s, you know . . . (gesturing to Amir) Well, he’s younger than me, you know, and this was in England. (laughing)

(Amir laughs)

You know, it was in England, not the United States.

Maybe you didn’t get that, but you know, see everyone’s laughing now. They’ve forgotten that the Soviet Union did very well for 40 years, and of course there’s lots of differences between China and the Soviet Union.

But, you know, I would say, you know, you have to reform this political model if you want to really have enduring prosperity.

Hal Weitzman: And is there any appetite for real fundamental political reform? Do they sense that that message that you said that economic growth is not gonna come unless there’s that fundamental—

James Robinson: No, no, absolutely not, quite the opposite. I mean, they have some strategy for sort of consolidating the power of the Communist Party. You know, they think they can adjust with the anticorruption drive and the term limits for the people at the top. So I think quite the opposite.

You know, I think they’re trying to figure out what will help them sort of stabilize their power, but I don’t think they have any intention whatsoever of giving power away. Even elections are just a way of . . . Local elections are just a way of trying to figure out: Could this help us stabilize power? Could it help us select better people for the party?

Hal Weitzman: Randy, what’s your sense of the prospects for reform, let’s say, in the financial sector and state-owned enterprises in China?

Randall S. Kroszner: It’s very, very tough. We talk about all the political economy in the US and how difficult it is to make change. I think in this system, it’s just as difficult. Although it may be centrally planned, there are very important power bases that are vying for keeping their slice of the pie.

So I don’t think it makes it easy to just sort of say, OK, we’re gonna reform this or reform that. Ultimately, economic growth comes down to the number of hours worked and the output per hour. And China has been incredibly fortunate because they’ve had so many people, tens of millions of people entering the labor force each year from the hinterlands who, although they were part of China, were not really part of the economy. They’ve come in to the coastal areas, to the large, large cities, and so you’ve seen this just astonishing boom.

But now China’s population is aging. We’ve passed the peak in working-age population. So unless you have growth of output per hour and growth of productivity, you’re not gonna be able to sustain economic growth, and the only way to do that is to introduce more competition, have reform.

That’s broadly how the people in power talk about it, but I think the key is gonna be whether they will execute, and it seems that what James is talking about seems to be a real problem for making those reforms, introducing more competition, allowing some failure in the system to allow productivity growth, ’cause without that we don’t have the positive shocks of tens of million of people coming into labor force each year. You’re just not gonna be able to grow like China has.

Amir Sufi: And one of the things that I think is pretty interesting in terms of where the cyclical and the longer-term political issues that James is emphasizing come is actually whenever I talk to people who work in China who are based in the United States, and I ask them what they think the prospects are for China, they often times say, people seem very scared.

And they don’t mean just in terms of how people were scared in the United States in 2008. They mean scared in terms of things like missing businessmen, missing hedge-fund managers who are shorting the market. And so you can imagine that that’s gonna have a big amplifying effect on any downturn.

When people start to worry so much they’re not gonna invest, they’re not gonna buy cars, they’re not gonna build homes, and so that could end up cycling into a worse economic downturn.

Hal Weitzman: OK, James Robinson, more generally there’s an assumption, isn’t there, that when times are bad, it can provoke, it can prompt reform to be executed.

For example, in Latin America, a lot of people have said in an economy like Brazil or Argentina, where they’re already experiencing bad times and probably more bad times to come, that it’s more likely that they will introduce the kinds of reforms they need for long-term economic growth.

Is that a valid assumption?

James Robinson: Well I think, I mean, I think you can certainly find examples, you know, countries which are reformed in the crisis, but you can find lots of other examples of countries that have disreformed in a crisis. So I don’t really think there’s a robust—

Hal Weitzman: What do you mean by disreformed? Well, I mean, think about the case of Argentina. You know, it was the massive crisis that brought the Peronists and Kirchner back to power, and they’ve spent the whole time reversing many of the improvements, you know. They’ve been renationalizing things that were privatized previously. You know, they’ve been taking a grip on the society, on the agricultural sector. They’ve been, you know, undermining, you know, the bureaucracy, you know, predating on the private sector in a quite extraordinary way. Controlling prices. You know, you can’t even get reliable information out of the Argentine government. No one believes the statistics.

So, you know, that was a crisis that brought this political machine back to power. So I think you can find many examples like that.

Think about where did Chavismo come from? How did Chavez get into power? That was on the back of a massive crisis, you know, falling real wages, increasing inequality, huge economic crisis in Venezuela. That’s what put Chavismo in power.

So I don’t think that’s a robust generalization at all.

Hal Weitzman: OK, so you do not expect necessarily any big reforms in Argentina, Venezuela, and Brazil, and those countries that are really hurting because they produce commodities and those prices have crashed?

James Robinson: No, I think you could make the opposite argument. You know, that when things are going very badly, this sort of clientelistic way of doing politics actually has more traction with poor people. You know, they’re even more reliant on the state for handouts and favors and so, you know, I think theoretically you could make the opposite argument.

Hal Weitzman: OK, Randy Kroszner, with some former economic superstars like Brazil and China now slowing down, what does that mean for developed countries, which are now having to bear the burden of growing the global economy, particularly the US? Can the US carry the global economy on its own?

Randall S. Kroszner: So the US is a very big trading partner in the world, but it doesn’t depend on the rest of the world as much as other countries do. So Germany, China, Brazil, pretty much any other major country of the world whether developing or developed, trade is a much more important part of total GDP.

The US is a bit more self-contained, so the challenges that are in the rest of the world are not gonna have as much of a negative impact on the US as they might have on other countries.

The US has grown reasonably steadily through the last few years. Quarter to quarter a lot of variation, but about 2 to 2.25 percent growth. We’re kind of sliding along at about this rate, no matter what’s happened, whether it’s tragic terrorist events, whether it has been declines in oil prices that are supposed to have this great consumption dividend, which don’t seem to have come in. So out of the positive or negative shocks, we just seem to have kind of continued along.

I think that’s likely to continue to be the case for the US. But obviously we have to look for potential ripples that’ll come back from other countries. If there is a crisis in the Middle East, if there is a crisis in China, of course, that could have an impact on the US.

Hal Weitzman: OK, and what about the Federal Reserve, because a lot of countries have looked to the Federal Reserve and have enjoyed very low interest rates we’ve had, and now we’re at this start of this tightening cycle that’s gonna carry on, how could that effect, you know, developing economies that are now struggling?

Randall S. Kroszner: So certainly there’s been a lot of garment rending over this over the last year or two, about the potential for the Fed to raise rates and then capital flowing out of these countries. But I think it’s largely been anticipated that the Fed would begin to raise rates, but raise rates very gently. And so we’ve gone up one-quarter of a percentage point.

A lot of people seem to think that a quarter of a percentage point, the world was gonna be made or broken over that. If the world is so fragile that 25 basis points, one-quarter of a percentage point, is gonna make that much difference, then there’s nothing that the Fed can do, positive or negative, that’s going to impact things.

I think there’s been a long anticipation of the Fed’s move. I think that’s helped to reposition both countries and markets to be better ready for this. Some have reformed; some haven’t, so they’re still going to be hit.

But also I think going forward the Fed is gonna be on an extremely gentle path. I see very little prospect for inflation in the near to intermediate term, and so without some more inflation coming back in, I think it’s gonna be a long time before the Fed takes the next step. And actually I think the second increase in rates is gonna be even more difficult than the first.

Hal Weitzman: Does the Fed care about the rest of the world, because sometimes you hear people like Christine Lagarde have said the Fed should, you know, look at the global effect of interest-rate policy. The Fed has largely sort of dismissed that.

Does it care?

Randall S. Kroszner: Well, you have to remember that every central bank is created by its own government. It’s given a mandate to focus primarily on its domestic economy, so that’s the mandate of the Fed, as every other central bank in the world. The IMF has a mandate to look internationally, so it’s no surprise that Christine Lagarde’ll have a different perspective than Janet Yellen, ’cause they’re given different mandates from the origin of their institutions.

That said, the Fed certainly does look at those impacts because they want to see how those impacts are gonna come back and affect the US. Generally, the Fed thinks that a stronger US economy is gonna be the best thing for the world economy. And so what can strengthen the US is going to be the key. They’re certainly going to look for channels of financial fragility as well as real fragilities coming back, hitting the US, but the primary focus has to be on the US, as it is for every other central bank in the world.

Hal Weitzman: OK, Amir Sufi, what do you think about the US as carrying the global economy?

Amir Sufi: Yeah, I think it’s a great question ’cause, you know, we already know that Brazil is undergoing a severe economic downturn. They just, I heard, canceled Carnival, like most of the cities, so I mean this is a serious economic downturn when the Brazilians are canceling Carnival. And so then the question I think becomes is how exactly will that affect the United States.

And I completely agree with Randy, if you look at the direct exposure of the United States in terms of a cash-flow kind of calculation, it’s actually quite low. And so then you start to have to ask yourself, you know, how exactly will a potential severe downturn in many emerging markets affect the United States? And I think it actually will affect the United States primarily through what I would call an asset-price channel.

And so what we teach in Introductory Finance is that asset prices are a function of expected cash flows and the discount rate you use to discount those cash flows. We know that the actual cash flows probably won’t adjust much, but my big concern, if there is one, and I’m not so pessimistic on this front, but is that the discount rate may dramatically change in the US because of concerns of what’s going on in emerging markets.

This is what technically is called the risk premium effect. You can think of it as just people getting scared. And we know if you look at the single day reaction for example, in August when the Chinese stock market had a major correction, the S&P 500 fell 10 percent over a period of three or four days. And you could never justify that kind of movement from changes in what we think the cash flows of the US were gonna be. The only way China can affect the US stock market so dramatically is if people are worried about the world in general, and therefore use a higher discount rate to discount those cash flows.

So then the follow-on effect, the question is, if there is an asset price correction in the US, which I think a lot of people are worried about already in the last 10 days or so, we’ve seen a correction in the S&P 500, will that generally have a bigger impact on the overall US economy through standard wealth effects, through people buying less? Will it affect house prices? I think that’s the question.

I don’t have a definitive answer to that question. I think we look like we’re gonna have a correction of the S&P 500. It’s already started, but it’s a little bit harder to know how the knock-on effects on the US economy, how large they will be. My baseline is that they won’t be large, and we’ll probably continue to muddle along with two and 2.5 percent growth, but not anything too much more robust, and not any kind of crash.

Hal Weitzman: What about the rest of the developed world, eurozone and Japan both in trouble? Do you expect any real substantial growth from them this year or in the next few years?

Amir Sufi: I think the short answer is no. I think that what we’re seeing in those economies that I think reflects some deeper problem—I don’t know if I would call it secular stagnation as others have, as [Harvard’s] Larry Summers has—but these really low interest rates that seem very difficult to budge from being very low is, in my view, an indication of some problem with these economies, and I am an economist who believes that demand can be constrained even in the long run into the point it starts affecting supply. People haven’t been working for so long. Skills deteriorate.

So I’m quite worried about both Europe and Japan on this front, so I think that while I don’t necessarily think it’s just secular stagnation, that there’s this chronic, you know . . . We don’t have a good explanation of exactly what we mean when we say secular stagnation, do we mean low productivity growth? Do we mean chronically constrained demand? But in any case, I think what the secular-stagnation hypothesis has isolated the focus on, which I think is right, is why are these interest rates so chronically low in both Europe and Japan?

I think the difference between the 10-year German Bund and the US Treasury I think is something like 160 basis points in nominal terms, which is just very high. And so there’s something going on in both the eurozone and in Japan that seems to be keeping these interest rates very low.

Hal Weitzman: OK, Randy Kroszner?

Randall S. Kroszner: Following up on that, I think there’s a different expectation about inflation that the US Fed, although it hasn’t generated high inflation or it certainly hasn’t even generated its goal of 2 percent inflation, is more likely to be able to fight deflationary outcomes than in Japan or the eurozone. I think that’s part of what’s accounting for it, but I do think that there are other factors.

So certainly there’s slower population growth in Europe and in Japan, but when you look at productivity, if you look on a per-worker basis, it actually isn’t nearly as dire as it might seem. Japan has had significant shrinkage in its workforce, but the output per worker has not been shrinking at the same rate. They’ve been having acceptable, not gangbusters, but acceptable productivity growth.

So that gives me a glimmer of hope there. But I think Amir is right that there’s something fundamentally different that’s going on in terms of market expectations, something fundamentally different in their prospects that are being reflected in low interest rates. This is not just a function of central-bank policy. This is something that I think is broader than that.

Hal Weitzman: OK, James Robinson, I want to turn to immigration, which was one of the huge stories of 2015, and is likely to be a trend that’s gonna shape economies and politics for the next few years, and with it the rise of anti-immigrant politics. What effect could that have on economic growth?

James Robinson: Well, you know, I tend to think of it as being great for economic growth. You know, economists—

Hal Weitzman: You mean, immigration?

James Robinson: Yeah, absolutely, I mean, you know, who are these people? You know these are people, you know, who overcome immense barriers to get out of where they were and move somewhere else, you know.

When I go around the world and people ask me, you know: What’s so good about the United States and why is it so economically successful? I always say that, you know, well, there’s always problems, but the edge that the United States has over everywhere else is this immense welcoming . . .This is gonna sound very self-serving since I’m British, but this immense, you know . . . they’re just so welcoming of foreigners, and that’s not true about Britain. It’s not true about China. It’s not true about anywhere else in the world. It’s just a remarkable thing.

And the US has been able to suck talent and entrepreneurship and ideas into it for a couple of hundred years now, and I think that’s a huge part of the story of the economic success of the United States. And you know, you see the panic of Europe. They just don’t know how to deal with it, you know, and you see this rise of this xenophobia.

You know, I think that the basic story is that this is great for economic growth or potentially great, but obviously, and you know, maybe it’s great for the United States in a sort of relative position because they’re the one place that has the kind of institutions and the mentality and the history of being able to deal with this and integrate these people into society.

Hal Weitzman: Although in the United States as well you’ve seen the rise of, kind of, dangerous anti-immigrant politics as well.

James Robinson: Well, you know, it’s an election. It’s democracy. You know, people have the right to, you know, air their opinions and try them out, and you know. But I don’t think that’ll be very successful as a political policy or political platform to be honest with you. It seems to me that, you know, this country is full of immigrants. It was built by immigrants, and everybody understands that.

Hal Weitzman: OK, and as you say in Europe, there’s this huge demographic problem, the aging population and the influx of refugees could actually help deal with that.

James Robinson: Right, so that’s one economic benefit. I mean that’s not really what I’m thinking about . . . I’m thinking much more about, you know, the talent and the ideas and the creativity and the energy and, you know. And I think, you know the backlash against, you know, the concern about terrorism or whatever, you know. These people, they’re fleeing from terrorism. OK, so the odd terrorist merges in. You know, I don’t think that takes away from, you know, from not just the human aspect of it, you know, or the human imperative to do something, but all the economic benefits from it.

You know, the terrorists who blew up the World Trade Center didn’t come in a boat to the United States. They flew business class, you know, and took flying lessons in Florida or something. So you know, terrorists are always gonna wheedle their way in and do damage, you know, if they’re obsessed enough and determined enough. And so, you know, what’s the counterfactual? You know, there wouldn’t be any terrorism if these immigrants weren’t flooding in? No, of course there would be, you know, and sure we have to deal with that.

But, you know, I just think that there’s lots of potential economic benefits. You’re identifying one, which is this aging population. You bring a lot of young people into work. I mean, I guess that’s not what I would focus on, but you know, there’s lots of pluses from an economic point of view it seems to me.

Hal Weitzman: OK, well on that note our time is up. My thanks to our panel, Randy Kroszner, Amir Sufi, and James Robinson.

For more research, analysis, and commentary, visit us online at chicagobooth.edu/capideas and join us again next time for another The Big Question.

Goodbye.

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