The slump in spending by consumers and businesses may have caused global pain, but the eagerly awaited United States recovery promises to make a world of difference.
By Rob Shapiro
In the first half of 2008, the United States headed into what seemed to be a normal business downturn triggered by a doubling of energy prices, although a few perspicacious analysts warned that something more fundamental was happening, at least in housing prices. They were correct: a bubble had pushed up housing prices for a decade—not only in the US, but across most advanced economies—drawing in many of the large institutions that provide finance in the US and much of the world to create and purchase highly leveraged securities based on bubble-inflated mortgage values and their unregulated derivatives. When the bubble deflated and then burst, many of those securities crashed and pulled down the derivatives based on them. The financial institutions heavily leveraged in these instruments saw their capital reserves drain to the edge of insolvency or beyond. Normal capital flows slowed and then largely froze, first in the US and, quickly enough, in other economies bound to the large American institutions through global capital markets. Thousands of businesses that depend on regular credit lines found themselves credit-deprived and began to cut their investment plans, orders and workforces.
Millions of ordinary people held mortgages on homes whose values were falling sharply. They found themselves abruptly poorer; and like most people in such circumstances, they cut back sharply on purchases. As the financial crisis and falling housing values collided with the downturn, the combination created cascading losses across the economy, completing a vicious circle. Strapped financial institutions held back credit to businesses and consumers, businesses pulled back further on their spending and employment, consumers pulled back further as well and depressed demand for everything businesses produce, more of the financial institutions’ assets deteriorated as businesses and homeowners found themselves increasingly strapped, and the economy spiralled down faster and further.
This historic economic unravelling was not simply a matter of bad judgment and bad luck. Certain features of the global economy contributed to these developments, features which will be with us when the crisis and recession have passed. For example, the wages and incomes of most US citizens had stagnated, or nearly so, throughout the 2002-07 expansion, so millions of households maintained strong consumption by using mortgage refinancing and home-equity loans to convert their home equity into cash. When home values suddenly fell, millions were left with mortgages larger than their homes were now worth; and many millions more had few resources to cushion their lifestyles from the downturn. The result has been a more severe decline in consumer demand and business investment than normal for even a serious recession.
The dynamics that held down wages and incomes despite healthy growth and strong productivity gains—and not only in the United States—represent new developments based on rapid globalisation. From 1990 to 2006, the share of everything produced in the world that was traded across borders increased from 18 to 30 per cent, the fastest increase and highest level ever seen. As thousands of large companies built out global supply and product networks, and tens of thousands of new companies joined the global economy, competition has intensified.
The result in the United States has been a change in job creation and wage growth. After the recessions of the 1970s, ’80s and ’90s, it took 12 to 24 months to return to pre-recession job levels. After the 2001 recession, the shortest and mildest in 50 years, it took 42 months to get back to those levels. Similarly, in the 1990s, productivity increased by an average 2.5 per cent a year, and average wages increased accordingly by 2.2 per cent a year—just what economists expect in free labour markets. Yet, while productivity grew 3 per cent a year from 2002 to 2007, the best record since the 1960s, average real wages declined modestly. These unexpected and unwelcome developments will still be with us when the crisis passes.
The United States’ problems became the world’s problems, because globalisation connects much of the world’s prosperity to spending by American consumers and businesses. In 2007, the US imported US$2.2 trillion in goods and services, more than the entire output of all but four other countries. So, when US demand for imports falls sharply, economies and companies around the world quickly feel the pinch. In effect, globalisation plus a worldwide downturn produces the chief result of protectionism without new laws. In the last quarter of 2008 and the first of 2009, trade flows fell at rates of 20 to 30 per cent across much of Europe and the US, and at 30 to 40 per cent in China, Japan and much of Asia.
A severe recession in a globalised world economy has other destructive effects. Unprecedented waves of foreign direct investment in the last decade have helped drive rapid modernisation and growth across the developing world. But the sharp decline in credit flows and the deep recessions in Europe, America and Japan have sharply depressed these investments. And since the United States is also the world’s most globalised economy—with nearly 30 per cent of its FDI in the developing world—the economic setbacks in the developing world translate into more problems for the US.
Globalisation was one of the sources of the housing bubble that triggered the problems. For more than a decade, capital markets have been on the leading edge of globalisation. While global trade has expanded twice as quickly as global output for the last 20 years, global capital flows have grown twice as fast as global trade. This reflects in part the successful global networks of many large financial institutions. In addition, however, the basic process of globalisation has increased the worldwide supply of capital. For example, as international financial institutions built out their global networks, they went to the wealthy families that own many large businesses in such places as Indonesia, Egypt and a dozen others, and explained that they could float shares in their enterprises, retain their majority control, and pocket hundreds of millions of dollars. In this way, most of that wealth entered the global capital pool.
The rapid modernisation driven by FDI and globalisation also produced sharp income gains in many developing countries. As their middle classes have expanded, the savings pools in these nations have rocketed. Much of those savings also made their way into the global capital pool.
These vast increases in national and global capital pools normally would lead to serious inflation. Yet, with globalisation’s intensification of competition limiting the “pricing leverage” of businesses—their ability to raise prices—the inflationary pressures generated by the vast increases in national and global money supplies are being channelled into asset prices, starting with housing but also extending to equities, art, and other assets in most countries. When the current crises pass and normal growth returns to the US and other nations, these developments will still be part of globalisation and capable of triggering new rounds of asset bubbles.
The United States has been the prime agent of the current global conditions, and not only because many other economies rely on its imports and FDI flows. The US also is the chief architect of the economic reforms which most developing countries have adopted. The Clinton administration drafted the basic rules of the World Trade Organisation, requiring countries as disparate as China, Egypt, India and Argentina to gradually dismantle state-owned or state-sanctioned monopolies or duopolies and open their economies to foreign imports, foreign investment and domestic competition. The success is evident in the results: from 2000 to 2005, the global economy grew faster than in any other five-year period on record. The openness which helped drive growth, however, leaves countries vulnerable to a cascading international downturn.
In its early days, the Obama administration put in place large new programs to address the immediate consequences of these developments, including the world’s largest stimulus package, near-zero short-term interest rates, unprecedented expansions in its monetary base and elaborate efforts to stabilise the housing market and financial institutions. Financial experts and economists have questioned these new measures for being either too radical or too timid; and legitimate questions remain about whether these measures can resolve the problems sufficiently to allow the United States economy to recover in a rapid and vigorous way. The Obama administration’s hope is that the measures, combined with the considerable structural strengths of the US economy, will be sufficient to unlock a recovery; and that the return of economic growth will reduce the stresses on households, banks and businesses. If this strategy does not work, the Obama administration is likely to correct its course with another stimulus round and with additional, more extensive supports for people facing foreclosures and financial institutions facing insolvency. Whatever path the US follows to the next economic expansion, its own recovery will help drive a revival in many other countries.
When that happens, the global economy may be both quite different and much the same. The differences will be most apparent. The age of market fundamentalism—a perspective and confidence that markets alone produce the best available outcomes—will be over, at least for a while. The coming period of more extensive economic and social regulation could dampen US and global growth to some degree. For example, if institutions have to demonstrate their financial probity and health before being allowed to purchase or issue asset-backed securities or their derivatives, and if they have to set aside capital equivalent to 15 or 25 per cent of the value of the securities and derivatives they issue or purchase, there will be fewer of them and less of the economic activity that produces their underlying assets. But if these regulations avert another financial system meltdown, it will be well worth it.
Other factors also could dampen US growth in the next expansion. For example, the United States almost certainly will put in place a broad policy on greenhouse gas emissions. Whatever approach it adopts, one result will be higher energy prices and costs, and consequently another brake on growth. Again, if these measures help avert climatic changes, they will be worth it.
The United States also will almost certainly move towards universal health care, and try to slow the rate of medical cost increases, especially on the public side. Even as Washington accepts greater government involvement in the US economy, it is unlikely to include the price and wage controls in medical care used in most other advanced countries. So, US medical costs will continue to rise fairly sharply, and American taxpayers, businesses and health care providers will bear the costs of universal coverage. The result again could be slower growth, especially outside the health care sector. If these measures help produce broader and better health care, they also should be well worth it.
The United States’ success in slowing health care cost increases, along with energy and pension costs, will help determine whether it returns to the broad income gains and strong job creation of the 1990s. If it cannot slow future cost increases, the next expansion may not produce much more economic progress for most Americans than the last one. And without fast-rising asset values for Americans to draw on to sustain strong consumption, US imports may not return to the strong levels of recent years—which would mean slower growth in much of Europe, Asia and Latin America.
All of these dynamics testify to the pivotal global role of the United States. The US has been the world’s largest economy since at least the end of World War I—some trace it to the late-19th century—consistently producing between 20 and 25 per cent of worldwide GDP, except during the period following World War II when its share rose to nearly 30 per cent. Its GDP per person also has consistently been the highest of any large economy, at four to five times the worldwide average, since at least 1920. Over this long period, many economies have grown faster than the US—for example, Germany in the 1930s, ’70s and ‘80s; Japan from the 1950s to the ’80s and China since 1990. Others, such as Britain and France have generally receded. The US’s position as the largest economy, however, has remained a constant; and since the 1990s, it has been the world’s fastest-growing, large advanced nation.
For all the problems it faces, this position is not about to change. Most other large advanced economies face more daunting challenges. Over the next decade, the labour forces of Japan, Germany, France, Italy and most other major economies will begin to contract by as much as 1 per cent a year, depressing their growth rates. The US’s large-scale immigration and higher birth rates among recent immigrants will keep the American labour force growing at a healthy rate even as its baby busters replace its baby boomers in the workforce. Moreover, even as China, India and many other large developing countries grow faster than the United States and the world overall, the US will retain critical advantages that will be especially valuable to developing economies.
This brings us to the so-called ideas-based economy. Since the mid-1990s, US companies have invested more in intangibles—mainly the intellectual property of patents and trademarks, but also databases, branding, organisational changes and the training or human capital to use these ideas—than in all physical assets, from equipment to land and buildings. This shift to intangible assets, of course, coincides with the rapid improvements and spread of computers, software and internet technologies, which play large roles in the development and application of the products and processes that win patents and trademarks, the databases and branding, and even organisational changes and high-level training. The shift to an ideas-based economy also is evident in the way investors value US public companies. In 1984, the market value of the physical assets of the 150 largest US public companies—their book value—accounted for 75 per cent of the total value of their stocks. A firm was roughly worth what its plant, equipment and real estate could be sold for. By 2004, the book value of the top 150 US corporations accounted for just 36 per cent of the total value of their shares. Nearly two-thirds of the value of large US corporations comes from what they know and the ideas and relationships they own.
Creating and applying valuable new ideas always has been the most important factor determining a country’s economic progress. Since the pioneering work of Nobel laureate Robert Solow in the 1950s, economists of every stripe have recognised that the development and application of economic innovations has more impact on how fast a country grows and how much the incomes of its people rise, than the amount of capital they invest or even the progress in the education and skills of the workforce. Some 30 to 40 per cent of all the gains in wealth and productivity made by the US in the 20th century can be traced to innovation in its various forms—not only the development of new products and technologies, but also new materials and processes, new ways of financing, marketing and distributing things, and new ways of organising and managing a business. The increases in the US capital stock account for 10 to 15 per cent of that progress, while improvements in the education and skills of American workers explain 20 to 25 per cent.
Judging by how much businesses now invest in ideas and how much investors value this, the economic role of innovation is still expanding. The central economic innovations of our period, information technologies, have become an important feature of globalisation. It is not surprising that elaborate information systems pervade finance and manufacturing in the world’s most highly developed countries. What’s extraordinary is that the same systems have so quickly become part of most large and medium-sized businesses in China, India, Nepal and Peru, as well as every corner restaurant and repair shop in small-town North America and Europe.
The United States continues to be the country that generates more economic innovation in business organisation and practices as well as technology and practices than any other, and it remains the society most adept at adapting innovations into its economic life. The US spends, on average, a larger share of its GDP on research and development than other advanced nations. Moreover, in the competition to lead global innovation, what matters is how much is invested, period, and how well a country’s economy commercialises what comes out of it. Here, the US has broad and growing advantages. In 2003, for example, it spent nearly US$300 billion on research and development, compared to US$210 billion by all of Europe, barely US$100 billion by Japan, and less than US$80 billion by China—and the gap in 2003 was larger than it had been in 1990 or 1995. That’s one reason why American companies have vastly increased their pre-eminence in high-technology products. Less than 20 years ago, Europe, Japan and the US each claimed a little more than 25 per cent of the world market share in this area; by 2003, the US share had reached almost 40 per cent, while Europe’s fell to about 18 per cent, and Japan had just about 10 per cent. It’s also one of the reasons why American inventors and companies have early leads in many promising areas of biotechnology and nanotechnology.
If the United States maintains these leads, globalisation will increase their significance. American hardware, software and internet companies will have a leg-up as China and India go increasingly digital. Over the next decade, China should be as digital and wired as some European countries today, and India also will make substantial (if smaller) strides. American companies will provide many of what will be the latest generations of these technologies.
These technologies are also part of the essential infrastructure of globalisation, from supply-chain management to local product development and marketing. As global production and demand for almost everything continues its upward trend after the recession passes, the global manufacturing and retail companies that have integrated IT most successfully will be in the best position to meet much of that demand. An exception could be financial services, where the US also led other advanced countries in foreign markets before the crisis, but now finds itself without its Lehman Brothers and AIG.
The United States’ greatest strength in innovation, however, lies not in its development and spread, but in how Americans use them. Despite what many people believe, a succession of studies have found that how much a company or a country spends on IT makes little difference in how productive it becomes. From 1995 to 2005, European businesses invested nearly as much in IT as US firms, relative to the size of their economies. Yet, the productivity of the industries that spent the most on these technologies increased by 3 to 4 per cent a year in the US, compared to little or no change in Europe.
One reason is that American companies are managed differently, and the differences affect how they use technology. For example, US businesses more often use performance measures to set pay increases and promotions, which create powerful incentives for managers and workers to get more out of the IT they are provided. By contrast, large European and Japanese companies still typically base their employees’ pay and promotions on tenure and union rules. Other rigidities in the European and Japanese economies make it harder for firms to get as much advantage from their IT investments. For example, labour laws and social conventions that limit firms’ freedom to fire or reassign most workers in many European countries often prevent them from reorganising their domestic operations to make their IT investments work for them.
A worker’s educational level also affects how well he or she adapts when a company introduces new technology. Here’s a surprise for many people: US adults average more than 12 years of formal education, compared to barely seven years for Italian adults, less than nine for adults in France, and less than 10 for British, Japanese and Germans adults. Substantially more young Americans also enrol in post-secondary education or training—69 per cent, compared to between 45 and 58 per cent in major European countries and Japan, respectively. Some of these differences will probably fade in coming years, as the share of young Europeans going on to college has risen sharply in the last 15 years.
It’s indisputable that many large European and Japanese companies deeply involved in global markets are at least as productive as any American firm, and in sectors such as automotives much more so. Moreover, globalisation is fast spreading the best practices of the most successful and IT-enabled corporations. For example, after Wal-Mart, the world’s most profitable and IT-intensive retailer, bought Britain’s supermarket chain Asda in 2005, Britain’s number-one retailer, Tesco, quickly adopted much of the Wal-Mart model. Still, US multinationals are generally more productive than European or Japanese multinationals. For example, researchers measuring productivity in Britain found that plants operated there by US multinationals were almost 40 per cent more productive than the average domestic British plant, and 10 per cent more productive than the plants of British multinationals in their own home market.
Overall, the productivity gap between the United States and Europe and Japan together increased steadily from 1995 to 2005, pointing to the US’s single, most important economic advantage: intense competition, especially in the service companies. The US’s more bare-knuckled competition at almost every level makes its workers and companies less secure in a time of galloping globalisation and technological progress, and especially during economic crisis and deep recession. It also forces those who want to prosper to adopt the latest technologies and business practices, or even come up with new products, processes and ways of doing business. And American companies and workers, accustomed to dealing with intense competitive pressure, will be better equipped once the current crisis passes to deal with the legal and economic changes that ensue.
A financial crisis and serious recession will change the lives of millions, and adept leaders operating within a flexible political system can respond in ways that, at a minimum, reduce the likelihood of their happening again. That is what happened in the United States and other countries in the 1930s, in Sweden after its financial crisis in the early 1990s, and in Korea and Taiwan after the 1997-1998 Asian meltdown. By contrast, countries with dysfunctional or inflexible political systems may react less constructively, such as Russia after the 1999 collapse of the rouble. There seems little doubt the US will respond constructively to the current crisis. The crisis quickly helped produce an upheaval in US politics, with the election of Barack Obama. In the first months of the new administration, new policies were introduced to stimulate the economy and address the housing and financial market problems.
While trillions of dollars in paper assets have been wiped out, the basic physical and intellectual assets of the US economy are intact. Moreover, the crisis and recession have not damaged its other strengths, especially the capacity to develop and apply economic and social innovation. The crisis may actually increase the value of these capacities, as companies, workers and governments are forced to figure out how best to adapt to the new conditions everyone will face as we emerge from the current period. The pre-eminent economic role and place of the United States in the world will carry on.