Ask The Expert - Responses
ASK THE EXPERT - PROFESSOR MARK HARRISON RESPONDS
Throughout the first week of our theme 'Contextualising the Crisis', we asked you to submit your questions for Professor Mark Harrison, Department of Economics, on the topic of 'The Ongoing Recovery from the Financial Crisis'. Two questions were selected and you can read Professor Harrison's responses below. If you did not submit a question this time, we would still like to hear your views on the 'Share Your Thoughts' page.
“Recently I read an article in the Financial Times about whether or not the US FED could go bankrupt. After some further research there seems to be a whole conspiracy regarding this topic; that the US dollar has served its time as the global currency. E.g. the UAE is thinking of finding an alternative solution to the dollar when it comes to the pricing of oil. As well as this, China and Russia have now stopped using dollars as their trading instrument between each other. I wonder how you see upon this, will the dollar lose its position as the global currency and what serious turmoil would the world face in that case?”
The United States' share of the global economy has been shrinking since World War II. This is an inevitable result of the escape from poverty of a billion or more people, first in postwar Europe, then in Asia and south America. At the same time the United States economy (with at least one fifth of global output), is still twice the size of China’s in real terms (with one tenth)1. It’s worth remembering that London was still able to be the world’s financial centre in 1913, when the UK accounted for less than one tenth of global output (Maddison 2010)2.
The United States will not lose its global leadership role, especially financial leadership, any time soon. Average incomes in China, per head of the population, although rising rapidly, are still only about a tenth of American incomes. Chinese living standards are relatively lower than that, because more of China’s income is swallowed up by government purchases and investment outlays. As long as it’s important for financial services to be where the money is, there’s no real reason, as yet, for the global industry to relocate en masse to Shanghai.
Today, the dollar accounts for around 60 per cent of identified international reserves around the world (IMF 2010)3. The euro accounts for most of the rest. The yuan will not replace the dollar as a global reserve currency in the foreseeable future. The most important reason is that China is not supplying yuan to the global economy for other countries to hold. For the yuan to become a reserve currency, there has to be a supply. This is currently impossible for China to achieve, given its huge trade surplus. Rather than export yuan, China is importing U.S. Treasury bills. Alternatively, countries that want to hold yuan as a reserve currency must demand them in large enough quantities that their price will rise by enough to eliminate China’s trade surplus and turn it into a deficit. For the time being, China does not want this. At present there is no alternative to the dollar, particularly given the difficulties of the Euro area.
The main long term threat to the role of the dollar in global finance comes as much from America as from China. The world’s past willingness to absorb dollars has given America a tremendous advantage in borrowing from the world to finance its imports and government borrowing. The problem is that America has been able to exploit this “exorbitant privilege” (as Valéry Giscard d'Estaing once it) by oversupplying them to the world. But the more dollars the world holds, the larger are potential claims on the U.S. economy, and the more the world may worry about the U.S. ability to meet these claims. Beyond a point, this must undermine confidence in the dollar and its role as a reserve currency.
The ultimate reason why dollars are being oversupplied to the world is America’s structural fiscal deficit. Today the U.S. is the only major economy without even a medium term deficit reduction programme. The Financial Times reported recently (Jan. 23): “The Congressional Budget Office projects that the debt to GDP ratio will hit 90 per cent by 2020; the International Monetary Fund projects that it will reach 115 per cent. These are levels usually associated with Italy or Greece. The US will reach them within nine years.” Beyond 2020, the U.S. debt will continue to rise because of rising welfare entitlements and liabilities. This can become a vicious spiral, with more and more of the U.S. budget being taken up by servicing the rising debt.
This prospect gives China (and other Asian economies) every reason to stop accumulating dollars, turn away from export promotion, and learn to consume more. When that happens, as it will one day, there will be a sharp decline in global demand for U.S. Treasuries. Then, the United States may find itself borrowing at much higher interest rates, and will be forced into sudden large-scale deficit reduction.
To conclude, there is no real question about the Federal Reserve (the central bank of the United States) going bankrupt (but see Reuters 2011)4. The long term issue is the solvency of the U.S. government, not the Fed. American solvency cannot be assured without a significant deficit reduction programme, and this would be better undertaken now in a deliberate and phased way than postponed until it is forced suddenly by the refusal of international markets to accept more U.S. government debt. If this came about, it would certainly be associated with a lot of turmoil.
“What do you think will be the impact of the Coalition's plans to eliminate the structural deficit (in one Parliament) on economic growth in the medium term?”
I think economists will still be arguing about this in twenty or thirty years’ time, in much the same way that military historians continue to argue about the campaigns of past wars. Why so? Two reasons. First, like military campaigns, radical fiscal adjustments tend to take place infrequently, under unusual circumstances, and without randomized controls that would make possible the clear identification of cause and effect. Second, like military plans, fiscal plans are often adapted and fine tuned in response to both economic and political circumstances. It is typically unclear whether the modifications are tactical retreats or strategic U-turns. Both of these factors complicate the identification of cause and effect.
Rapid change can be stressful and hurtful. Gradualism gives people time to make otherwise painful adjustments.
What do we know? In the UK, this year’s public borrowing will run at around 10 per cent of GDP. Three quarters of that is structural in the sense that, when the economy has returned to full employment, the increase in net taxes will put back in only about 2.4 percentage points. (These figures are from the independent Office of Budget Responsibility.) One reason that so much of the deficit is viewed as structural is because the recession is thought to have destroyed a significant amount of capacity, reducing output and tax revenues at full employment in the future.
A structural deficit will not go away when the economy gets back to full employment. As a result, the public debt will rise indefinitely. A growing economy can sustain a rising public debt, but the debt must not grow faster than output. From this alone, taking the UK structural deficit down to zero in five years might seem unnecessarily ambitious. The problem is that the UK public debt has doubled in proportion to GDP in only ten years. It is now more than 60 per cent of GDP and will reach 70 per cent before it stops rising. To bring it down again requires both a tighter fiscal policy and resumed economic growth.
There is plenty of evidence in the mainstream economic literature about the long term effects of fiscal choices on economic growth. Growth is assisted when public spending and public debt are low relative to output (Barro 19915; Reinhart and Rogoff 20096). Taken together, these two results make it important that public spending is covered as far as possible by taxation rather than borrowing. Growth is not harmed by having a social safety net or redistributive taxation, as long as benefits are conditional on behaviour (such as retraining and seeking work) and means tests, and take only the least productive out of the workforce (Lindert 20067); and as long as taxes fall on labour and consumption more than on capital (Arnold et al. 20118). It is also important to keep the economy open to competition from foreign trade, to put an external discipline on the corporate sector. From a medium-term point of view, therefore, the British fiscal and welfare reforms would seem to conform roughly with what the literature recommends.
In the short term, the Cameron-Clegg administration is juggling competing needs.
The same literature does not offer such clear guidance about the speed of adjustment. Rapid change can be stressful and hurtful. Gradualism gives people time to make otherwise painful adjustments. But gradualism also gives people time to express doubts, lose their nerve, and mount resistance. When the outcome of Plan A looks uncertain, having a Plan B sounds sensible, but can also play into the hands of those who object to Plan A on principle. On June 4, 1940, Winston Churchill did not say: “We shall fight them on the beaches, but if it gets sticky we shall call for time out to rethink.” Nor are there good models of gradualism elsewhere. When we look across the Atlantic, we see an administration doing nothing in the face of a fiscal outlook that must end in either correction or disaster. That sort of gradualism seems to be based more on division and myopia than a commitment to do what is necessary in a gradual way.
In the short term, the Cameron-Clegg administration is juggling competing needs. The public finances, the needs of vulnerable people who depend on public services, the demands of public employees, and political obligations to voters and constituencies, all pull in different directions. The “right” people (depending on your criteria) do not always win out. For example, to protect universal benefits like my bus pass (that I should pay for) and my winter fuel allowance (that I do not need), the government is making damaging cuts to things I would prefer to see protected, including the armed forces and local government funding of care services. However, the security of the nation, and of vulnerable people in it, can also be damaged by a failure to control fiscal deficits and public debt. In fact, they have already been put at risk. That is why we now have the bad choices we face today.
Professor Mark Harrison is a professor of economics at the University of Warwick and a senior research fellow at the Centre for Russian and East European Studies of the University of Birmingham. He edits the Political Economy Research in Soviet Archives (PERSA) working papers at www.warwick.ac.uk/go/persa. Harrison was one of the first Western economists to work in the Russian archives following the fall of Soviet communism. His work has brought new knowledge about the Russian and Soviet economy into mainstream economics and international economic history, especially through projects on the two world wars.
Mark Harrison is a research fellow and a former national fellow (2008–2009) at the Hoover Institution. He is an economic historian and specialist in Soviet affairs, currently working on the Hoover Sino-Soviet Workshop led by Hoover research fellow Paul R. Gregory.
Mark Harrison has written or edited a number of books including Guns and Rubles: the Defense Industry in the Stalinist State, published in 2008 in the Yale-Hoover series on Stalin, Stalinism, and the Cold War; The Economics of World War I (Cambridge University Press, 2005); and The Economics of World War II (Cambridge, 1998). His articles have appeared in leading journals of comparative economics, economic history, and Russian studies. He received the Alec Nove Prize from the British Association for Slavonic and East European Studies for his book Accounting for War: Soviet Production, Employment, and the Defence Burden, 1940-1945 (Cambridge, 1996).
He has a BA in economics and politics from Cambridge and a DPhil in modern history from Oxford.
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