Is another global economic crisis inevitable?

Speaking at the London Business School recently, former RBI Governor Raghuram Rajan warned that the global economy was "slowly slipping" into The Great Depression-like problems of the 1930s and the central banks need to sit together and define new "rules of the game" to find a better solution to deal with it. Rajan has been the IMF's Chief Economist and is among the few to have rightly predicted the financial crisis of 2007.

The essential problem we need to confront is how to rectify a world economic system that has gone hopelessly wrong and resembles nothing like what was envisaged in the early 1940s. To understand the situation we are in, imagine living on an island as a part of a small group, and in this group people are assigned specific vocations and tasks. In this system, one person makes clothes, another shoes, someone pots and pans, someone grows food and someone else prints money to facilitate exchange of goods and services. So the shoemaker exchanges his goods with another for money and in turn pays with that money for food or whatever. Since everybody in this system can produce as much as possible, the person who prints the money will be best off among all because he can buy whatever he wants and pay for it with his own money. Take this one step further then. Producers who come to hold more paper than they need then start leaving it with the person who prints them to hold.

In 2019, the World GDP was about $88 trillion and the per capita GDP was $11400. During the past ten years, the WGDP growth declined from 3.13% to 2.47%. In 1960 the WGDP was $11.35 (constant 2010) trillion. The WGDP was just $1.1 trillion in 1900 and took half a century to grow fourfold to $4.01 trillion. The big leaps began after 1971 when US President Richard Nixon unilaterally delinked the US dollar from the international gold standard. In 2000, it scaled $51 trillion.

The total world merchandise trade in 2019 was $19.5 trillion, with China (without Hong Kong) the biggest player accounting for $5.31 trillion with a trade surplus of $422 billion. The top five global traders account for 50.6% of global trade. The EU’s share of world trade is $4.49 trillion and the USA’s is $3.91 trillion also accounting for about a quarter of world trade. The most preferred global currency is the US dollar. The total world reserves in 2019-Q2 was $11.8 trillion, of which 61.8% was held in US dollars, 20.5% in Euros, 5.7% in Yen and 1.8% in Renminbi.

Almost all of these reserves are held by individual countries in the form of bonds, mostly earning very small or even no interest rates. This is like money deposited in a bank, but in reality it is money being lent to the issuing country. Since the reserves are mostly in US dollars and Euros, the issuing countries have little reason to hold much of them as reserves. The USA’s total reserves amount to about $132 billion. Contrast this to India’s $535 billion (including $35 billion Gold) and China’s $3300 billion.

In 1995, advanced economies held around 67% of total foreign exchange reserves, with 82% of these being allocated reserves. By 2011, the picture had been flipped on its head: emerging and developing countries held 67% of total reserves.

The purpose of sharing these three world economy snapshots is to provide a general backdrop to how we have come to this pass. A situation where the rest of the world invests in the USA, so that it in turn can splurge on itself. When it is short, it can just print some more dollars, which the rest of us lap up quite happily. Every time the USA goes into convulsions due to its innate profligacy and economic mismanagement, the world economies go into a tailspin, because the USA is the world’s biggest importer and it is where the world keeps its money. Now let’s turn to how the system actually works. Countries like China and India produce goods and services at low cost for consumption in the USA, which pays them in dollars which they, in turn, deposit in US banks. Since money cannot sit still, this money in US banks is then lent to Americans, who today have the highest per capita indebtedness in the world, to splurge on houses, cars, flatscreen TV’s, computers and play stations, most which they can often ill-afford. Thus, in effect the rest of the world is plying the USA with cheap credit, encouraging it to splurge even more. Unfortunately there was and is no global regulator to caution the US on its profligacy or force it to mend its ways.

At the Breton Woods Conference of July 1944 that took place under the fast receding shadow of WW2, Lord Keynes had in mind an elaborate scheme that called for the establishment of an international reserve currency called “bancor” administered by a global central bank. But this had to be shelved in the face of American obduracy. This central bank would have been vested with the possibility of creating money and with the authority to take actions to ensure balanced trade. As outlined by Keynes, countries with payment surpluses should increase their imports from the deficit countries, thereby ensuring foreign trade equilibrium.

But the United States, as a likely net exporter and creditor nation, and eager to take on the role of the world's economic powerhouse, thwarted the Keynes plan. The US contingent seemed more concerned about inflationary pressures in the post-war economy. Its delegate Harry Dexter White argued that an imbalance was a problem only of the deficit country. The determined obduracy of White is now under some cloud after he was unmasked as a Soviet spy. Did he scuttle “bancor” at Moscow’s insistence to ensure the crisis we now are living through?

The international system was unilaterally abrogated when in 1971, US President Richard Nixon delinked the dollar from the gold standard. In the absence of a standard and a useful regulatory function for the IMF, the great private banks were given a licence to run amok. We are now reaping the bitter harvest.  With the US dollar as the world’s preferred reserve currency, the US and its even more profligate citizens have an apparently endless access to easy credit to satiate their sundry appetites. Ironically, the ever-growing annual US trade deficit becomes the de facto engine of growth for many economies, such as China, the ASEAN countries and even India.