International Economics: Threats to the World Economy

Newaglish

Recently an economics lecturer had my class read "The risks ahead for the world economy", an article by Fred Bergsten (director of the Institute for International Economics in Washtington, D.C.) in The Economist (11.09.04).

Five major risks threaten the world economy. Three centre on the United States: renewed sharp increases in the current-account deficit leading to a crash of the dollar; a budget profile that is out of control; and an outbreak of trade protectionism. A fourth relates to China, which faces a possible hard landing from its recent overheating. The fifth is that oil prices could rise to $60-70 per barrel even without a major political or terrorist disruption, and much higher with one.

Most of these risks reinforce each other. A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates. A sharp dollar decline would increase the likelihood of further oil price rises. Larger budget deficits will produce larger American trade deficits, and thus more protectionism and dollar vulnerability. Realisation of any one of the five risks could substantially reduce world growth. If two or three, let alone all five, were to occur in combination then they would radically reverse the global outlook.

Now, I'm aware this article is a year old, but most, if not all of this still applies. In fact, the oil shock is already underway. Regardless, my question was about the economic thinking of some of the statements - could anyone explain the reasoning behind the following?

• A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates
• A sharp dollar decline would increase the likelihood of further oil price rises
• Larger budget deficits will produce larger American teade deficits, and thus more protectionism and dollar vulnerability

I have a vague idea but am basically finding it hard to get my head around this stuff. Help appreciated

mike65

Newaglish wrote:

• A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates
• A sharp dollar decline would increase the likelihood of further oil price rises
• Larger budget deficits will produce larger American trade deficits, and thus more protectionism and dollar vulnerability

I have a vague idea but am basically finding it hard to get my head around this stuff. Help appreciated

So basicly you want a crash course in macro economics? On Boards? Are you mad?!

A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates

This is open to debate. One might argue that the oil shock is'nt really a shock anymore its now 'business as usual' and we are learning to cope. Argueably its supply not price thats really important as has been demostrated with the disruption to refining in the Gulf of Mexico area.

The dollar collapse is a relative thing. After all was'nt the dollar trading against the euro at about 85 eurocent only 2 years back? The sky has'nt fallen in for either them or us.

As for higher inflation/interest rates, if we assume that high priced oil and low valve currency equals low growth, then interest rates (the price of money)would be cut to stimulate activity. The budget deficit is the fly in the ointment - that has to be paid for by someone but George W Bush cuts taxes for the wealthy instead!

Larger budget deficits will produce larger American trade deficits, and thus more protectionism and dollar vulnerability

A budget deficit can be tackled by boosting the economy, by keeping interest rates low which means consumers have more money to spend on cheap imports from China which adds to the US trade deficit. The USA has been importing more than it exports for decades now. This could lead to a protectionist mentality a la Pat Buchanan, which would be bad for the economy which would cause the dollar value to fall.

All of what I've said is open to debate as it depends on what economic/fiscal ideology one belives in.

Mike.

madramor

Newaglish wrote:

• A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates

Oil price increases price of goods and service increase
= inflation = increase in rates

the currency collapse price of imports increase
= inflation = increase in rates

high budget deficit, the government need to reduce this so
to earn extra cash = increases in rates

Newaglish wrote:

• A sharp dollar decline would increase the likelihood of further oil price rises

if the dollar is worth less you need more to buy the same amoun
of oil therefore the price of oil rises

Newaglish wrote:

• Larger budget deficits will produce larger American teade deficits, and thus more protectionism and dollar vulnerability

a budget deficit means the us has to borrow from abroad which
increases its trade deficit.
so in order to reduce its trade deficit it could impose caps
on foreign imports

defiantshrimp

Newaglish wrote:

A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates

If there is a further oil shock it would presumably push up the price of oil products and thus the price of energy, this should in turn filter through the economy driving up general prices (if businesses pass on their increased cost base which they eventually must) the rate of inflation. The fed could avert this through higher interest rates (and likely would) but high unemployment would result and recession would probably result.

The dollar collapse is likely to cause inflation in the US to rise since it means imports will become vastly more expensive and also that oil will become even more expensive (as prices in US dollars).

The budget deficit could cause inflation to rise since a large deficit means the government is pumping money into the economy.

These factors don't necessarily result in higher interest rates but the threat of inflation they bring will.

Newaglish wrote:

A sharp dollar decline would increase the likelihood of further oil price rises

Only in terms of US dollars, in fact it could lower the price of oil in Euro/Yen terms since a collapse in the dollar is likely to significantly lower US and world demand.

Newaglish wrote:

Larger budget deficits will produce larger American teade deficits, and thus more protectionism and dollar vulnerability

The trade deficit does indeed increase the likelihood in dollar vulnerability. Since a trade deficit means America is importing more than it exports the markets way of correcting this would be to decrease the value of the dollar so as to increase exports and decrease imports and bring them closer to equilibrium.

Newaglish

Thanks guys for your replies so far. Thanks defiantshrimp in particular, your explanation is particularly clear. I just have a few questions - maybe you could clear them up?

... The fed could avert this through higher interest rates (and likely would) but high unemployment would result and recession would probably result.

How do higher interest rates avert inflation? Is it because higher interest rates discourage capital investment, thereby reducing national income and thus aggregate demand and price increases?

How would unemployment be a result of higher interest rates? The GDP would drop because of reduced investment, but would this have an effect on jobs? Wouldn't recession be a result anyway, purely as a result of reduced investment?

The dollar collapse is likely to cause inflation in the US to rise since it means imports will become vastly more expensive and also that oil will become even more expensive (as prices in US dollars).

The thing I don't understand here is the idea that oil becomes more expensive to the US. The way I understand it, the dollar loses values against other currencies. If the dollar drops in value (relative to a basket of other currencies), surely the value of a $60 barrel of oil will have an equivalent drop in value? Or will the oil prices increase to compensate?

A sharp dollar decline would increase the likelihood of further oil price rises

.
.
.

Only in terms of US dollars, in fact it could lower the price of oil in Euro/Yen terms since a collapse in the dollar is likely to significantly lower US and world demand.

This might be in some way an answer to my question above. How would a collapse of the dollar lower world aggregate demand? (I'm thinking that's what you meant, though I'm not sure)

The trade deficit does indeed increase the likelihood in dollar vulnerability. Since a trade deficit means America is importing more than it exports the markets way of correcting this would be to decrease the value of the dollar so as to increase exports and decrease imports and bring them closer to equilibrium.

Would increasing interest rates also be a (less satisfactory) solution? It would bring the balance of payments into line (due to huge inflows of cash), although spur recession. Right?

In general your post was a great help. Sorry for plaguing with more questions, hope I'm not completely lost. Briefly covering macroeconomics before jumping straight into Int. Ec. doesn't seem all that practical anymore :P

OfflerCrocGod

Newaglish wrote:

The thing I don't understand here is the idea that oil becomes more expensive to the US. The way I understand it, the dollar loses values against other currencies. If the dollar drops in value (relative to a basket of other currencies), surely the value of a $60 barrel of oil will have an equivalent drop in value? Or will the oil prices increase to compensate?

The producers get paid in dollars and they use them to buy goods from the rest of the world so if the dollar is worth less something from the EU requires more dollars to buy.....so they increase the price of oil. Mind you the bastards OPEC could probably absorb some of the price increases.

defiantshrimp

Hey no problem, I love economics and we should have more economics on boards!

Newaglish wrote:

How do higher interest rates avert inflation? Is it because higher interest rates discourage capital investment, thereby reducing national income and thus aggregate demand and price increases?

You are half right, you neglected the role of the consumer! When the Fed/ECB or whatever increases interest rates it essentially increases the cost of borrowing money and simultaneously makes saving money more attractive. So some consumers and businesses willing to borrow money at say 2% will not do so at 3%. Also consumers and to an extent businesses will now find it more attractive to save more of their income since there is now a greater return. Finally consumers and businesses may have to meet higher interest repayments on existing debts thus reducing their disposable incomes. These combined effects will reduce the amount of consumer spending and business investment. Thus reducing aggregate demand in the economy. This will act to reduce demand-pull inflation (where growth in demand exceeds growth in supply).

Newaglish wrote:

How would unemployment be a result of higher interest rates? The GDP would drop because of reduced investment, but would this have an effect on jobs? Wouldn't recession be a result anyway, purely as a result of reduced investment?

Higher interest rates don’t necessarily cause unemployment in and of themselves but the associated reduction in demand would usually. The decrease in demand means businesses will be producing less goods and also cutting costs to increase sales. To produce fewer goods a firm will use less factors of production, labour being one of them! Also downsizing may occur in an effort to reduce costs.

Newaglish wrote:

The thing I don't understand here is the idea that oil becomes more expensive to the US. The way I understand it, the dollar loses values against other currencies. If the dollar drops in value (relative to a basket of other currencies), surely the value of a $60 barrel of oil will have an equivalent drop in value? Or will the oil prices increase to compensate?

You are misunderstanding the way oil is priced. If a barrel is at say $60, this means in exchange for a barrel of oil one could purchase $60 worth of goods. If the dollar were to decline in value, this does nothing about the intrinsic value of the oil but since $60 will not buy what it used to, the price of oil in dollars will rise (supply, demand and all other factors held constant). This will not affect the price of oil in euro/yen/sterling, again assuming that supply and demand and so on are held constant. So to summarise, the dollar is just a means of pricing the oil, it is not the dollars that count but what can be exchanged for the dollars. So when the dollar falls in value, each dollar buys less!

Newaglish wrote:

Would increasing interest rates also be a (less satisfactory) solution? It would bring the balance of payments into line (due to huge inflows of cash), although spur recession. Right?

The topic of interest rates and the balance of payments in America is a tricky one. At the moment America is borrowing from abroad to fund its imports. So essentially when America buys something from China, the Chinese receive dollars. In turn what often happens at the moment is that some of these dollars are lent back to America by the Chinese (or whoever) buying a treasury bill allowing the process to start again. Interest rates are able to be so low because of the huge inflow of capital to America. Higher interest rates would attract more money into America and increase the demand for dollars. This would cause the dollar to rise in value and so make importing more attractive and thus could worsen the trade defict. But then again higher interest rates could sharply reduce American demand (as shown above) and thus the demand for imports. It is too complex to call! The best and most probable solution is for the value of the dollar to fall as I discussed before.

Hope this helped!

Newaglish

So, let me see if I've got this straight.

One of the big risks threatening the world economy is the US trade deficit. This trade deficit must be funded somehow. As official reserves cannot be run down forever and an increase in interest rates to attract foreign capital investment would dampen its own effect (in that the resultant increase in dollar value would spur import demand, worsening the balance of trade all over again), the best solution is for the dollar to lose value.

As a result of this oil prices would rise (for America). Political, terrorist or climate-related disruptions to supply could further increase prices (this risk has already come true following hurricanes Katrina and Rita). Increased energy and oil product costs will push up inflation rates, as these costs are passed on to the consumer.

To avert inflation, interest rates may be increased by the Fed, the ECB, etc. Borrowing becomes less attractive, hindering investment; saving becomes more attractive, reducing consumption; disposable incomes will be reduced as interest payments on existing debts increase. All this should rein in inflation, but as a consequence stunts economic growth and causes unemployment (arising from cost-cutting).

Alot of this reining in of inflation (and subsequent loss of growth) will have to be done in America (as they are so oil dependant). The knock-on effect of that is that their imports provide massive demand in other countries, including the EU. World demand (and therefore world growth) will suffer as a result.

Right?

What do you think about his viewing China as a risk? He says "China could be facing a hard landing following its overheating of the last years". How is this a risk to the global economy?

defiantshrimp

Yep, you've got it spot on! The trade deficit is a problem and the best outcome is a slow decline in the value of the dollar and also for American consumers to reduce their thirst for imports and for foreigners to buy alot more American goods. The worst is a sudden sharp decline in the dollar and a huge decrease in American demand which would have the nasty knock on effects you talked about.

There is an inevitability that China's growth must slow at some point. This is a risk in the sense that China makes up an increasing amount of world trade. If it tipped into recession that would cause instability in Asia and the world as a whole. Investors may try to withdraw capital from China en mass (think back to the Tiger crisis in the late 90's). It would impact on world growth. But it is not as great a problem as a recession in America since economically America dwarfs China. I wouldn't loose too much sleep about it, the media is a little obsessed with China at the moment. That is not to say that it is not important, just a bit overhyped.

Newaglish

Cool! Just sitting down and figuring out that kind of thing gives you a much better idea of the world economic climate. Glad I asked - thanks for the pleh! Now I can get on with the rest of the article, :P

OfflerCrocGod

defiantshrimp wrote:

There is an inevitability that China's growth must slow at some point.

It still has 200-300 million people to urbanise and employ in it's industries from it's rural areas; that number is a lower estimate as it doesn't include all the illegal Chinese who were never meant to have been born. I'd say China can look forward to another 20 or 25 years of good strong growth. After which things get bad as it's population gets older.

defiantshrimp wrote:

This is a risk in the sense that China makes up an increasing amount of world trade. If it tipped into recession that would cause instability in Asia and the world as a whole. Investors may try to withdraw capital from China en mass (think back to the Tiger crisis in the late 90's). It would impact on world growth. But it is not as great a problem as a recession in America since economically America dwarfs China.

I'm sorry but China's PPP is $7.3 trillion and the US's is $11.75 trillion "dwarf" is an overstatement especially considering China's growth in 5 - 10 years time it will be very close to parity with the US. If China goes into recession what will happen to the US housing market? All those T-Bonds could be dumped that will have a big negative worldwide effect. Granted the US is bigger and more important but I don't think China's impact is "hype". Beijing is increasingly influencing world markets. It's only a matter of time before they take over from the US as leaders.

REDZ

Newaglish wrote:

• A further oil shock, a dollar collapse and a soaring American budget deficit would all generate much higher inflation and interest rates
• A sharp dollar decline would increase the likelihood of further oil price rises

Hey I reckon....
If the dollar collaspes the fed will have to raise interest rates to make it more attractive to hold as currency, thus stabilising it. Higher inflation will result from more expensive imports for the US due to a lower dollar.
Oil is priced in dollars so if the dollar falls oil will rise.

defiantshrimp

OfflerCrocGod wrote:

It still has 200-300 million people to urbanise and employ in it's industries from it's rural areas; that number is a lower estimate as it doesn't include all the illegal Chinese who were never meant to have been born. I'd say China can look forward to another 20 or 25 years of good strong growth. After which things get bad as it's population gets older.

OK so I overstated my point a little. But it cannot continue at such a blistering pace, that is my point. It must slow, and when that happens it will be interesting to see the result. Also I realise China is very important in world trade (an interesting economist article talked about how China controls world monetary policy) but i meant that America is still a much bigger fish and Europe depends on them much more for trade than china, although trade in different goods I guess.

OfflerCrocGod

I wouldn't be surprised if China kept growing at a high rate for another 10 years, if not more, there is still a lot of growth left in the country and there are still many state enterprises that have to be shut down or privatised, there are also large numbers in the countryside who want good jobs. As for when it stops, well I don't think it will be a sudden collapse, it will be more a gradual wind down as spare capacity and space for growth diminishes.

infinite_in

The poorest country catch up the effect more quickly, the international community should take initiative for strengthening the international financial system, through trade, aid to help the poorest countries integrate into the world economy to grow more rapidly.