Global Economy and Financial System Likely to Remain on a Tightrope in 2011
Senior Fellow, RIETI
2010 marks historic year for the financial world
Year 2010 turned out to be another tumultuous year in which a flurry of global economic events unfolded. Indeed, it was a critical year, particularly on the financial and monetary front. In the realm of monetary policy, advanced economies, including Japan and the United States, adopted "non-traditional" monetary policy measures in a straightforward fashion. Roughly speaking, we have entered a new era of monetary policy in which the Bank of Japan (BOJ) purchases exchange-traded funds (ETFs) and real estate investment trusts (REITs) as part of its monetary policy operations. Last year, the international monetary system was severely destabilized. In Europe, which constitutes a major part of the advanced world, sovereign debt problems converged at once. In particular, Greece was effectively forced into fiscal bankruptcy.
Such major events not only occurred, they also caused various forms of friction between countries. Faced with severe economic conditions, advanced economies have continued to promote ultra-easy monetary policies. While such monetary stimuli have not yet spurred tangible recoveries in these economies, there has been a surge in speculative money flows from the advanced economies to developing countries and into the commodities markets, fueled by the extremely accommodative monetary regimes. Noteworthy are the emerging economies with rigid foreign exchange controls. China in particular has seen enormous inflows of speculative money as investors can earn a fairly good return by investing in such countries with limited or null foreign exchange risk. A flood of speculative money has in turn caused the economy and asset markets to heat up and inflationary pressure has risen to serious levels in China and other emerging countries. Against this backdrop, there emerged a significant north-south conflict over monetary policy.
However, emerging economies have their share of responsibility. Their rigid foreign exchange controls are one of the key factors inducing speculative international investment flows. China in particular continues to have its currency effectively pegged to the U.S. dollar (although the People's Bank of China has been gradually relaxing its control). The implementation of such rigid foreign exchange controls often becomes a source of international economic discord.
The issue of sovereign debt is another source of international contention. Economic conditions vary greatly across euro countries despite the fact that these countries share a common currency. Though some euro countries continue to face extremely difficult conditions due to the surfacing of sovereign debt problems, other countries such as Germany have been enjoying steady economic growth. And among the countries distressed by sovereign debt problems, there are significant differences in their domestic socio-economic conditions. Needless to say, countries sharing a single, common currency must also live with a single, common monetary policy. As such, upon which country should the European Central Bank focus its monetary policy is the next issue that needs to be settled?this has been creating a deep chasm among the euro countries. One emerging pattern represents conflict between the performers and nonperformers, with the latter group of countries demanding that Germany, a country with robust economic performance, provide them with more fiscal support if monetary policy cannot be loosened to a level sufficiently satisfying their needs.
Basic picture remains unchanged for 2011
Year 2010 can be defined as a year in which major events in the broadly-defined financial and monetary area caused a series of international conflicts. But why did we end up with a situation fraught with friction points? There are various factors contributing to each friction point. But for purposes of this article, I would like to focus on two major factors. One factor is the rise of developing countries in general, and China in particular. When looking at international conflicts, be it over monetary policy or foreign exchange control systems, we almost always see China or other emerging economies on one side of the conflict. While the presence of emerging economies remained relatively small, a conflict of interest between them and advanced economies was not so conspicuous. However, with the rise of emerging economies on the international scene, this conflict has become more intense. Even so, we believe that the situation is manageable so long as orderly capital flows from advanced to emerging economies continue. Such capital flows are beneficial to both sides because, from the viewpoint of advanced economies, emerging economies serve as a recipient of investment capital and deliver returns on investments, while emerging economies can use foreign capital inflows as leverage to achieve greater economic growth. However, a cause for concern is that at present there exists no mechanism for policy coordination in settling any disputes that could arise if the delicate balance of money flows between advanced and emerging economies is undermined for any reason or in the event that an undesirable event occurs on either side.
The fallout from the collapse of the housing bubble in the U.S. is another leading factor behind the uncertainty surrounding the world economy and the conflict between advanced and developing economies. The U.S. bubble, which developed in the 2000s against the backdrop of an easy monetary policy, burst in the autumn of 2008 following the failure of Lehman Brothers. This came as an enormous shock to the world economy. Thanks to massive emergency measures implemented by governments around the world, it appears that the world has managed to weather the crisis. That said, even though the worst-case-scenario might have been averted, the aftereffects of the crisis continue to persist. All in all, advanced economies remain on a tightrope and the removal of policy support measures at this stage carries the risk of seeing the economy quickly fall back into deep recession. Thus, bound by hand and foot, the central banks of advanced economies have been unable to find a way out of the current ultra-easy monetary policy.
Sweeping economic stimulus measures, implemented through fiscal and monetary channels following Lehman's collapse, were one of the remote factors that led to sovereign debt woes in Europe. In Greece, where solid fiscal discipline had been hard to come by in the first place, the implementation of fiscal stimulus measures caused a further deterioration in its fiscal position. Meanwhile, in Spain, monetary easing led to the development of a real estate bubble. Those factors together have given rise to European sovereign debt problems.
In the months following Lehman's failure, the world economy experienced an acute economic downturn described as a "once-in-a-hundred-years crisis." Running out of breathing room, governments around the world became increasingly inward-looking in their policymaking. This may have laid a foundation for intensifying international policy conflicts.
Neither of the two major factors?the rise of emerging economies and the fallout from the collapse of the U.S. bubble?will likely be solved within this year. On the contrary, it is expected that emerging economies will further increase their presence. And the aftereffects of the collapse of the U.S. bubble appear set to linger. For instance, in the case of Japan's asset bubble that began to develop in the latter half of the 1980s and reached its peak within a period of three to four years, it took 10 to 15 years to overcome the aftermath of the collapse of the bubble. Japan could or should have worked through this more quickly, and its experience may not serve as a good reference. Even so, the U.S. should expect that it will take a significant period of time to overcome the problems resulting from the collapse of the enormous bubble that developed over four to five years from the early 2000s.
Following the end of the Cold War, the international community has yet to establish a new world order. As the global community continues to search for a new international system, both Japan and the world economy at large will likely continue to be strained in 2011 on the monetary and financial front, as well as in the area of the real economy. Going forward, in considering the course for the Japanese economy, it will be important to view it within the context of a new, emerging global order.
February 1, 2011
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