Current World Economic Crisis: Positive Analysis
By Abdulaziz E Alattar
Mr Alattar is head of the Houston, Texas, office of Kuwait Petroleum Corporation.
The world’s current economic crisis has created a profound financial challenge and stumbling block to improving economic activities in various countries and regions. This article has been compiled as a brief synopsis of the world’s current economic crisis, pinpointing the causes and impacts and concluding with various economic propositions that have provided a stepping stone to overcoming the current economic contraction. The article includes a new stagflation index formulated to articulate the consequences of the crisis in particular countries. The methodology utilized to create the index relies on positive analysis, including objective causes and effects, based on facts and figures, rather than normative analysis based on subjective value-judgment analysis.
In 2007, the world’s economic crisis started with the subprime mortgage crisis originating in the US. This event is considered the worst financial crisis since the Great Depression of the 1930s. Subprime mortgage loans characteristically carry a higher than normal risk of default rate due to factors such as the borrower having a low credit rating and/or a history of non-payment. From an empirical standpoint, the subprime crisis initiated a negative amortization of subprime mortgages that directly led to severe global economic turmoil that continues to cause investors to lose confidence.
In response to these economic events, world political leaders, national ministers of finance and central bank directors coordinated efforts to reduce fears, but the crisis continued. At the end of October 2008 a currency crisis developed, with investors transferring vast capital resources into stronger currencies such as the Japanese yen, the US dollar and the Swiss franc, leading many emergent economies to seek aid from the International Monetary Fund and World Bank.
Subprime Mortgage Crisis
The widespread subprime mortgage lending crisis been attributed to the new business paradigm adopted by financial institutions to instill commercial opportunities and prosperity as a part of the deregulation implementation. This deregulation ultimately caused the money supply to be influenced significantly by financial institutions pursuing accommodative policies rather than central banks or the US Federal Reserve system.
As a result of embracing the new business paradigm, financial institutions began to give out more loans to less qualified potential homeowners with little regard to any potential negative impact. As housing prices began to rise, the same financial institutions encouraged homeowners to take on considerably higher loans in the belief they would be able to pay them back more quickly, overlooking the interest rates. Once the interest rates began to rise in mid-2007, the number of foreclosed homes also began to rise, and housing prices dropped significantly.
Indeed, the world financial system is intricately interconnected and was impacted as the subprime mortgage crisis rapidly developed and spread globally. As the crisis developed, it spread from the initial US credit crunch, with the European sovereign debt crisis resulting in some European bank failures, falling stock indexes and market value declines.
In early 2010 the situation became tense in Greece, Ireland, Spain, Italy, and Portugal. Iceland, the country which experienced the greatest crisis in 2008 when its entire international banking system collapsed, has emerged less affected by the sovereign debt crisis. Iceland’s experience is unique in that the government was unable to bail the banks out as other countries did. As a direct result of the economic crisis in the EU, especially in countries where sovereign debts have increased sharply due to bank bailouts, a crisis of confidence has emerged with the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other EU members.
The EU and US economies are deeply intertwined. Impacts of the EU sovereign debt crisis have created significant negative effects on the US’s macroeconomics, especially as related to trade. Additionally, trade is the major channel through which ongoing stress in the EU will affect the United States. In 2010, 22.5% or $412bn worth of US exports in goods and services went to the EU.1 A sharp economic downturn in Europe means demand for US products and services will decline significantly. This will cause a rise in unemployment rates in the US and economic slowdown.
In addition, an appreciation of the US dollar relative to the euro makes US exports to the EU more expensive. There is usually a significant lag of about 12-18 months between the depreciation of a currency and when its impact on exports is felt, but a sustained decline in the euro value relative to the dollar has a substantial adverse impact on US exports.
Shift Of Manufacturing From West To East
Another pivotal factor which led to a contraction in the Western economy, and in turn caused a balance of payment deficit and increase in the unemployment rate, is the shift of manufacturing. There has been a shift in manufacturing at the global scale from West to East. The manufacturing sector is growing rapidly in India and China and has shrunk in most advanced economies.
The recession exacerbated the manufacturing trend shift. Eastern economies have outperformed their Western rivals. US manufacturing diminished at a cumulative annual average rate of 1.4% a year between 2007 and 2009. Japan contracted by 8.5% and Germany by 5.4%.2 In contrast, Chinese manufacturing expanded 14.3% while India grew by 1.5%. The expansion of manufacturing in the East is attributed mainly to low wage costs, which has in turn forced many Western companies to close factories and move production from their home country to locations in the East.
This shift shaped a profound trade deficit paradigm in the East and West, and in particular the West imports more goods and services from China than it exports. For instance, the US goods trade deficit with China was $273.1bn in 2010. The US goods trade deficit with China accounted for 43% of the overall US goods trade deficit in 2010. In addition, the euro trade deficit with China was $225.18bn in 2010, compared to China’s trade surplus of $296bn.3
Additionally, the US runs huge trade deficits because China has been maintaining the yuan undervalued by 15-40% relative to the US dollar.4 The objective is to reinforce their exports. On the other hand, it could really be that the Chinese are cost competitive and it is cheaper to produce goods in China than it is to produce them in the US.
The Impact
The impact of the world economic crisis has been a sizeable negative effect on many countries’ macroeconomic performance, although the magnitude of the impact varies between countries. Although the outcome is dependent on the volume of the budget deficit in a particular country, there is a common economic turmoil denominator among these countries identified as stagflation. Stagflation occurs when the inflation rate is high and the economic growth rate is low, coupled with high unemployment rates. These dilemmas instill an economic instability in many parts.
Between 2008 and 2010, the world’s high inflation transcended the economic growth in many economies and contributed to profound economic contraction. Principally, higher inflation soaks up the economic growth and acts to reduce purchasing power parity (PPP). The world gross domestic product (GDP) increased and reached a rate of 4% in 2010 from a rate of -2.1% in 2009; however, the world inflation rate also increased exponentially, especially in emerging/developing countries. Moreover, global food prices were inflated by 26% in many parts of the world in 2010.5
In thriving economic environments, the real GDP growth rate is greater than inflation. Customarily, low rates of inflation of around 2% are generally regarded as acceptable because this helps to smooth relative price adjustments in the economy; however, very high inflation (hyperinflation) leads to instability in the financial markets and worker unrest, especially in emerging and developing economies. An example of this is seen in 2008, when Venezuela had the highest inflation rate of over 30%, Egypt’s inflation rate reached 18%, and Yemen’s reached 19%. India’s inflation rate reached 8.4% in 2008 and increased substantially in 2010, reaching 12%. Iran’s inflation reached 25% in 2008 but declined to 10% in 2010.
The disadvantage of high inflation is that it reduces the level of business investments, and increases the unemployment rate. When the rate of inflation is high, interest rates also rise. In addition, a high rate of inflation causes severe fluctuations in exchange rates and negatively affects international trade (encourages export and discourages import). It has been observed that the current inflation, not caused by high demand for goods and services, is driven by an increase in inputs costs including factors of production such as prices for raw materials, labor and capital.
Therefore, stagflation (high inflation and slow growth along with sustained periods of high unemployment rates) is very challenging in particular economies; an index has been formulated in this paper and applied to measure the impact of the hyperinflation on the economic growth for particular countries.
The New Index
According to economic textbooks, stagflation is a situation in which the inflation rate is high and the economic growth rate is slow; this situation increases the unemployment rate, because workforces demand high wages that the work market cannot fulfill. Therefore, in order to identify the rate of stagflation, a new index has been developed. The equation below determines the level of stagflation and economic performance as either poor or progress in a particular economy.
Index = GDP Growth Rate – Inflation Rate
The data (GDP and inflation) has been collected from the World Bank to determine the difference between the GDP growth rates in various countries from their inflation rate, by allocating an index to calculate the rate of stagflation for a particular economy at a given period. The outcome of the index is as follows:
Negative Index: stagflation appears in the economy, which indicates that the country’s economy has a tendency of poor performance. It has been observed that a persistence of negative index for more than two consecutive years’ results in the country facing economic instability. The lower the index the more destructive the impact on the country’s economy. Negative index is the outcome of hyperinflation and low real GDP growth rate.
Zero Index: rarely occurs and indicates the economy is coming into critical economic challenges.
Positive Index: reflects the economy in a particular country is expanding and excelling. The higher index indicates higher economic progress in a particular country. It has been observed that a positive index indicates a sustained economic performance and a stable social regime at a given period. Positive Index is the outcome of subdued inflation maintained at lower than real GDP growth rate.
Table 1 presents an index for selected countries from advanced, emerging and developing economies, from 2008 to 2010. In 2008, the world was experiencing deep stagflation – many economies recorded a very low index, due to high inflation, compared to real GDP growth rate. The lowest indexes were in Venezuela, Iran, Egypt, Yemen, and Syria. In 2009 the index improved slightly in many economies but remained on the negative side. In 2010, the world stagflation index shifted to positive, mainly in advanced economies such as in the US, Germany, Japan and France, and in some emerging countries such as Brazil, which indicated an improvement in overall economic performance. However, in other emerging economies such as Venezuela, Iran, Syria, Yemen, Egypt and Tunisia, the index remained intensely negative for three consecutive years.
China, the exception, is the only country that did not experience any negative index for three consecutive years, due to high GDP growth and low inflation. This was driven by high exports and low imports for goods and services in conjunction with increased international trade balance between 2008 and 2009. The index declined in 2010 because of rising inflation. In addition, India’s index is remarkable: it was declining and reached -2.3 in 2010 from -1.8 in 2009, despite the fact that the Indian GDP was growing. In this scenario, inflation was also increasing rapidly, especially for food. As a result, the country could prompt the central bank to pause on interest rate increases to decrease money supply.
In some European countries such as in Ireland and Portugal, their indexes remained in negative due to government deficits and debt levels. In 2010, they witnessed a recovery resulting from the European Central Bank’s bailout packages and imposing of fiscal austerity. Greece is the only country in the European zone whose index deteriorates from -3.2 in 2008 to -9.2 in 2010, due to the Greek government’s enormous debt, which is estimated at €216bn in 2010.
High unemployment rates are one of the major macroeconomic challenges facing a country when synchronized with stagflation. In normal economic situations, unemployment rates range from 4% to 6%, however, in 2010 various countries witnessed a two-digit inflation rise (Table 2).
In 2010, the unemployment rates in advanced economies such as US, France and Germany declined, but were still above normal economic situations. In China and Japan the unemployment rates remained within the range; however, the rest of the countries’ unemployment rates increased substantially. Spain is still considered to have the highest unemployment rate of 20.9%, followed by Greece with 16.3%, Ireland 14.3% and Portugal 12.1%. Additionally, the unemployment rates in Tunisia and Egypt increased in 2010 and reached 13.0% and 11.8% respectively.6
Based on these findings, one can say that the impact of the current global economic crisis has different impacts. First, stagflation is a serious economic challenge that every country can encounter. It puts more financial burden on individuals to purchase their necessary needs such as food. Less money is free for other investments or purchases. Second, high unemployment rates in emerging and advance countries amid increasing population create an unstable environment for development and expansion. Consequently, many economies around the globe become a threat to the indemnity of individual needs and desires for goods and services. The reality of these factors in turn causes outcry in many countries.
For instance, Arab Spring uprisings (Tunisia, Egypt, Libya and Syria) and current world protests, in economic terms are represented as ‘shock therapy’. Shock therapy is when a country undergoes economic turmoil and encounters hyperinflation, especially for food, coupled with high unemployment rates. The solution is a major change in the government and/or policy, to drop prices, open borders to free international trade and eliminate subsides. The objective is to increase government revenue, close budget deficit gaps and create new job opportunities. Due to the severity of the world economic crisis, the corrective changes were implemented very fast rather than gradually. As such, the changes required concerted action to restructure the economy and formulate a framework of law and regulation, and that does not occur overnight. When these frameworks are not supporting the changes, they may lead to a fragile economy rather than a well-functioning market economy.
Conclusions And Propositions
In conclusion, from an economic point of view, the world economic crisis’s roots are found in the time period of 2003 through 2007 when instant changes in the global financial regulation led to an increase in money supply, high and fast economic growth and resulted in deep stagflation. In order to capture this specific event, this article formulated the new index to calculate the level of stagflation in selected countries as a means to measure the economic impacts. It has been observed that when the index is low and negative, countries encounter deep economic difficulties (eg Tunisia, Egypt, Yemen, Iran, and Venezuela). Hence, these countries need either to improve their real GDP or subdue inflation.
The world economy has become so integrated that it has been observed that any economic decline or expansion in any particular country or region will affect other regions in one way or another. The current world economic crisis is a prime example of this integration. To overcome the negative impact of the current economic crisis requires solidarity between various economic elites and integration from different countries to reinforce economic collaboration and cross-border-investment. The objective is to refrain from creating further intense economic crisis. Frankly, there is no one silver bullet or panacea to extricate the global economy from the current crisis. Reform of fiscal and monetary policies, enforced austerity, eliminating subsidizes, lower energy prices, government spending adjustments in interest rate and taxes as well as stimulus plans are one side of the equation.
On the other side of the equation are a set of economic general principles and polices that can be reformed and implemented as impetus for thriving economies, with the objective of creating long term sustainable development rather than short term economic progress by expanding economic structure.
In advanced economies where free markets exist, there can be diversity and a combined economy (ie there can be expansion of manufacturing, service and agriculture sectors simultaneously). The intended diversity in an economy leads to reduced government debt and creation of new jobs. Yet each of the three individual components of a combined economy has its own competitive advantages as follows:
First, a manufacturing economy increases product exports internationally.
Second, a service economy increases research, development and enhanced specialized skills.
Third, an agriculture economy subdues inflation and provides the society with important needs such as food self-sufficiency (building new agricultural centers).
Combining all three economic sectors simultaneously will sustain economic growth and create new job opportunities, as well as create mutual economic dependence between the nations that enriches international trade and cross-border investment. The idea of countries combining differing economic types in a cooperative fashion can be referred to as creating a strategic alliance wherein two or more countries with differing strengths align their specific skills and experiences to create a situation where everyone benefits. This mutual benefit approach aims at reaching a higher level of positive growth rather than sacrificing anything to achieve nominal results.
Countries which encounter economic stagnation are often able to encourage foreign investment, despite a fall in prices due to the debt crisis. They are still devouring many investment opportunities in a variety of sectors including agriculture, financial, manufacturing, entertainment and tourism. This encourages cooperation between countries and creates mutual economic dependence by partnering countries that encounter budget deficit with countries that have budget surplus.
Finally, regulating financial institutions by independent agencies such as federal or central banks must resume in order to control the money supply, measure the economic performance of a particular country, oversee commercial banking activity and to ensure individuals and firms are saving with investments.
Table 1: Index Of Stagflation For Selected Countries (%)
Countries | Inflation (%) | Real GDP Growth (%) | Index (%) | ||||||
2008 | 2009 | 2010 | 2008 | 2009 | 2010 | 2008 | 2009 | 2010 | |
US | 3.8 | -0.4 | 1.6 | 0.0 | -2.7 | 2.9 | -3.8 | -2.3 | 1.3 |
France | 2.80 | 0.10 | 1.5 | -0.1 | -2.7 | 1.6 | -2.9 | -2.8 | 0.1 |
Germany | 2.6 | 0.3 | 1.1 | 1.0 | -4.7 | 3.6 | -1.6 | -5.0 | 2.5 |
Japan | 1.4 | -1.4 | -0.7 | -1.2 | -6.3 | 5.1 | -2.6 | -4.6 | 5.8 |
China | 5.9 | -0.7 | 3.3 | 9.6 | 9.2 | 10.3 | 3.7 | 9.9 | 7.0 |
India | 8.4 | 10.9 | 12 | 4.9 | 9.1 | 9.7 | -3.5 | -1.8 | -2.3 |
Brazil | 5.7 | 4.9 | 5.0 | 5.2 | -0.6 | 7.5 | -0.5 | -5.5 | 2.5 |
Russia | 14.1 | 11.7 | 6.9 | 5.2 | -7.8 | 4.0 | -8.9 | -19.5 | -2.9 |
Ireland | 4.1 | -4.5 | -0.9 | -3.5 | -7.6 | -1.0 | -7.6 | -3.1 | -0.1 |
Greece | 4.2 | 1.2 | 4.7 | 1.0 | -2.0 | -4.5 | -3.2 | -3.2 | -9.2 |
Italy | 3.4 | 0.8 | 1.5 | -1.3 | -5.2 | 1.3 | -4.7 | -6.0 | -0.2 |
Spain | 4.1 | -0.4 | 1.9 | 0.9 | -3.7 | -0.1 | -3.2 | -3.3 | -2.0 |
Portugal | 2.6 | -0.8 | 1.4 | 0.0 | -2.5 | 1.3 | -2.6 | -1.7 | -0.1 |
Tunisia | 4.9 | 3.5 | 4.4 | 4.6 | 3.1 | 3.7 | -0.3 | -0.4 | -0.7 |
Egypt | 18.3 | 11.8 | 11.3 | 7.2 | 7.2 | 5.3 | -11.1 | -4.6 | -6.1 |
Yemen | 19.0 | 5.4 | 11.2 | 3.6 | 3.8 | 4.0 | -15.4 | -1.6 | -7.2 |
Syria | 15.7 | 2.9 | 4.4 | 4.5 | 6.0 | 3.2 | -11.2 | 3.1 | -1.2 |
Venezuela | 31.4 | 28.6 | 29.1 | 4.8 | -3.3 | -1.9 | -26.6 | -31.9 | -31.0 |
Iran | 25.5 | 13.5 | 10.1 | 2.3 | 1.8 | 1.8 | -23.2 | -11.7 | -8.3 |
Source: World Bank outlook database (Real GDP and Inflation).
Table 2: Unemployment Rate For Selected Countries (%)
Country | 2008 | 2009 | 2010 |
US | 7.4 | 10.0 | 9.1 |
France | 8.2 | 10.0 | 9.6 |
Germany | 7.7 | 8.10 | 6.6 |
Japan | 4.4 | 5.20 | 4.3 |
China | 4.2 | 4.3 | 4.1 |
India | 8.0 | 8.5 | 9.4 |
Brazil | 6.8 | 6.8 | 6.0 |
Russia | 7.8 | 8.2 | 6.1 |
Ireland | 8.6 | 13.1 | 14.3 |
Greece | 7.9 | 10.3 | 16.3 |
Italy | 6.8 | 8.4 | 7.9 |
Spain | 13.9 | 18.3 | 20.9 |
Portugal | 7.8 | 10.1 | 12.1 |
Tunisia | 12.4 | 13.3 | 13.0 |
Egypt | 8.8 | 9.4 | 11.8 |
Venezuela | 6.1 | 6.6 | 8.3 |
Source: World Bank outlook database.
Notes:
European Commission, ‘Trade with US’ (www.ec.europa.eu/trade/creating-opportunities/bilateral-relations/countries/united-states/: Oct 28th, 2011).
IHS Global Insight,‘World Industry:Perspective’, June 2010.
European Commission, ‘Trade: Extra-Euro Area Trade In Goods’, (http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/Extra-euro_area_trade_in_goods: Oct 23rd, 2011).
Board of Governors of the Federal Reserve System: China US Foreign Exchange Rate (EXCHUS).
The World Bank outlook database (Real GDP and Inflation), 2011.
The World Bank outlook database(Unemployment Rate), 2011.
Copyright MEES 2011.
