Assessing the World Economy
Each year, Michael Milken, the American financier, holds a roundtable discussion in Los Angeles with Nobel Laureates to discuss the state of the world economy. NPQ’s monthly column for the Tribune Media Services, Global Economic Viewpoint, distributed the discussion to papers around the world.
This year’s panel includes Kenneth Arrow, professor emeritus at Stanford University, who was awarded the Nobel prize in economic science in 1972; Gary Becker, professor of economics and sociology at the University of Chicago, awarded the Nobel prize in economic sciences in 1992, and Myron Scholes, an emeritus professor at Stanford University, awarded the Nobel prize in economics in 1997.
I. Japan and Korea
MICHAEL MILKEN | Today, more than 50 percent of the assets of all the individuals in Japan—$12 trillion—are held in cash yielding less than 1.5 percent. Equities have declined by more than 80 percent, as have real estate values, over the last 15 years. Why has it taken so long to get Japan going?
GARY BECKER | There is a misperception about what has happened in Japan in the last decade. It has not had a serious recession or downturn or erosion of income. What Japan has had is stagnation: population stagnation and income stagnation. That means per capita income has been more or less flat during the ’90s.
Japan is a very rich country. I just visited Japan and was impressed by the amount of wealth there, not only in cash but also in the automobiles, in the department stores, in the clothing that people wear. And it has plenty of real assets—strong human capital, hard-working people and some very good international companies that can give any company in the world a battle for market share.
Mainly, the Japanese problems are twofold. They have been reluctant, for what can only be political reasons, to clean up the huge financial problem they have with a basically negative net value in a lot of the loans that they had extended. Instead, they have been giving additional loans to companies they know will have no chance of ever repaying them. By way of comparison, the United States moved much more quickly with a smaller problem in the savings and loans industry.
The second problem Japan faces, from a longer term perspective, is that it remains an overly closed, overly regulated market. It was never a major importer of foreign capital. It remains hostile to immigration despite its rapidly aging population and shrinking work force.
Despite all this, a lot of countries of the world would like to be in the Japanese position of being so wealthy. So, Japan is not in decline but recline—that is, stagnation.
MYRON SCHOLES | If a country has a primary deficit of 7 percent of GDP a year, and it is growing by less than 1 percent a year with a 120 percent debt-to-GDP ratio, that is not sustainable. Something has got to give.
Of course, Japan’s trade surplus with the rest of the world, and the willingness of its citizens to hold huge quantities of government bonds, are what has allowed the government’s continuing ability to finance huge deficits.
When the banking system failed in the early 1990s, it did so because the corporations failed. In effect, then, society ended up owning the corporations and the banks. But instead of saying "okay, we will have to recapitalize these socially owned assets to keep them going," what they have done is institute a system of forbearance. If effect, they’ve tried to sweep the bankruptcy under the rug with the hope that something, somehow was going to create value enhancement to bail them out of their predicament.
If you are the managers of these in-effect socialized companies or banks, then there is not really an incentive to do anything to upset the government. Thus, the bankers became very afraid of lending money to anyone other than Toyota—which did not need to borrow money—or push loans on already bankrupt companies, such as the so-called "zombie firms," because they did not want them to lose any more money.
Over the last five or six years the lending infrastructure that was in place has essentially disappeared. When small businesses ask for a loan, they can no longer get it from the local branch. The information is sent to the headquarters, and then the upper echelons decide whether a loan is to be granted. So excessive regulations, excessive rules, an inability to make decisions because of the forbearance problem, have caused a lot of the financial technology to wither. As a result, there has been starvation of lending to middle-market entities and middle-market activities. There is a lot of dead capital in Japan. Assets that could be leveraged for growth are just not being put to work.
MILKEN | The largest amount of capital that exists in the world today is invested short in Japan. When the US had the savings-and-loan crisis, we did not suffer this forbearance problem because we are not dependent on the banking system for capital, but look to the publicly traded markets to finance growth.
A company like Bank of America, which was the largest in the world at the beginning of the ’80s, has shrunk in real terms 50 percent since. But it did not slow down our economy.
KENNETH ARROW | There seems to be one factor that has not been taken account of, which is the very high savings rate of Japan. We tend to think of this as a good thing because it means provision for the future. But maybe some elements in Keynesianism are not dead.
The high savings rate means that the rates of return have been driven down to a level which some might interpret as the liquidity trap. There is not much competition for capital because there is so much laying around, so to speak.
SCHOLES | You have to be careful, though, because in a deflationary environment such as Japan, the real interest rate is much higher. If prices are falling, even by making nothing on your money you are making something because your ability to consume later at less cost obviously is enhanced.
BECKER | This is true. The Japanese are probably getting 2 or 3 percent return on money, even though the official rate is at zero. I would be very doubtful, however, that the high savings rate for Japan is a problem.
Not long ago most economists in the US were lamenting the fact that we had such a low savings rate while Japan had such a high savings rate, and that is why they were eating our lunch and were going to overtake us. And it did not happen.
People exaggerated the strengths of Japan and the weaknesses of the US at that time. And I think now somewhat of the opposite is going on.
There are, to be sure, real difficulties in Japan. Yes, they have an aging population. But they also have a hard-working, highly educated population, a skilled population, and very good companies. And high savings, in an environment where you can turn things around, will be very productive. In a stagnating environment, it is much less clear.
But in the longer pull, the high savings rate for Japan will be a benefit, even if they send some of it abroad, as they are doing, to China and elsewhere in Asia.
MILKEN | To summarize some of our thoughts: If Japan could get some of the regulatory and financial technology in place, it has some excellent opportunities for growth by lending again to small and medium business, creating jobs and getting the economy going. And still it has the capital that could fuel large parts of the world’s need—particularly in the rest of Asia—for access to capital.
SCHOLES | I would add a last point. Japan has to stop these public works programs, which are essentially doing nothing but wasting society’s resources and increasing government debt. They are not very productive. It is not very productive uses of capital.
BECKER | Initially, Japan’s debt creation was kind of a Keynesian pump-priming effort. They thought that by the government spending more and running deficits, they would be able to spend their way out of the recession. But what happened?
If you go back to 1992, there was not a high debt/GDP country. It is all a result of misguided policies in the ’90s to try, through deficit policies, to spend their way out of the recession. They diagnosed the wrong problem and they took the wrong solution to the problem. And that only created more trouble as a result. Trillions of dollars have been invested and still have not solved the problem. At this rate of debt growth, five years from now their debt/GDP ratio will be 220 percent!
The Costs and Benefits of Korean Unification
BECKER | In discussing the unification of Korea, it is important to separate the economic and the political issues, which is difficult to do. When you think of German unification, the terms were set more by political desire than economic judgment. While the politicians decided it was desirable to have a one-to-one conversion rate between the East and West German mark, economists knew then it was wrong when the two economies were at such different levels.
Clearly, economic unification would be in the interest of both South and North Korea so that people, machinery and goods can move freely between the two regions. They were once a single country; they have a long common history of being an independent nation. Therefore, there would be a natural yearning to have a considerable amount of interaction between the two parts.
However, moving toward a single country—political unification—presents problems that in some respects are more severe than those facing East and West Germany.
While the populations in North and South Korea are very similar, the relative incomes are very different. South Korea is much richer. The gap is much larger than even the large gap in incomes between East and West Germany. While the German income gap was probably on the order of 4/1, Korea is more like 10/1. Unifying such disparate standards of living raises a whole set of difficult questions. How do you try to reduce that gap? What kind of transfer of payments must take place? What kind of taxes will be imposed on the South Koreans in order to eliminate that gap in a reasonable amount of time?
West Germany had a $100 billion surtax per year in order to finance East German unification. Relative to the Korean per capita income, that would probably have to be larger for South Korea.
That 10/1 income gap has to be closed for any kind of political unity. You cannot have a country integrated now where one part of the country is earning one-tenth of what the other part of the country is earning. And the only way you are going to close that in the short run is by transfer payments—taxes on the South Koreans to finance the transfers to the North Koreans.
MILKEN | It sounds to me like we are talking about $1,500 per person in South Korea per year for a while, to allow this to happen. Perhaps there might be a referendum to ask people in South Korea of they would be willing to spend $1,500 per person per year for 10 years to combine their country with the North?
ARROW | That is roughly what the West Germans are paying now, still, 10 years after the reunification. The Korean cost will be at least that, but probably higher. Of course, given the threat that North Korea presents to South Korea, it may be more beneficial than not paying it. East Germany didn’t pose much of a threat to West Germany as such. The North Koreans pose a great threat, particularly because of the geographic location of Seoul just south of the DMZ, right near the heavily armed North Korean troops stationed there.
There are boons, too, but they are going to take a long time to realize. For example, there is trainable manpower. But if the German experience is any guide, we are talking about a generation or more before this transformation takes place.
The price is going to be enormous. And, probably, a good part of it will be paid by North Koreans migrating South to seek work in industries that already exist. In fact, something like that is happening in Germany, too.
II. Germany and The Euro Bloc
MILKEN | What is prosperity to a person in Germany today?
ARROW | It is clear that the Germans have a somewhat different idea than Americans of what they want. There are several ways in which the German society, in the way it allocates its resources, is different. In judging the performance of Germany, one must take that into account.
Obviously, the negative of their system is a high unemployment rate, which it would be hard to justify by any set of values whatever. But there are clear pluses—for example, leisure time. The Germans have much more leisure. They take longer vacations; the workweek is shorter. If one were to do a simple correction for the calculation of national income by substituting the preference for leisure versus work at the present wage rate the conclusion would be that the German per-capita income is really not very different from American per-capita income.
German rates of growth are comparable to the US over any extended period of time. Further, Germany has a very elaborate health service. Though it may be even more inefficient than the British system, it is a lot less expensive than the American model.
Additionally, the distribution of income is considerably more equal than that of the US.
Thus, the common conception that Germany’s performance is bad is not really correct. Apart from the employment question, which I think is an indictment, they are doing quite well. The German system has done fairly well for its people and should not in any way be regarded as some kind of failure.
BECKER | Germany did extremely well up until 1990. Nobody would question that. By almost any measure, coming out of the devastation after World War II, they had the German miracle. West Germany had very rapid rates of growth with relatively little income inequality. There was low unemployment.
Their real problems came with the ’90s with the integration of East Germany. The major mistake they made in integrating East Germany was the exchange of one East German mark for one West German mark despite the reality that East German productivity was far below that of West German productivity. Their "real" market rate of exchange was much different.
Maybe politically fixing the rate at that level was necessary, but it was a mistake from a purely economic point of view. And the Central Bank of Germany thought it was a mistake at the time.
As a result, Germany today is not a country with happy campers. The East Germans resent the West Germans and the West Germans resent the East Germans.
The former East Germany today has an unemployment rate of close to 20 percent now, while it is perhaps 8 percent in the West. The younger people are doing relatively well. But the older people have a very dismal economic situation with little chance of getting a job. They are supported mainly by transfers—a surtax on West German income that is transferred to the East Germans.
This is not a win-win situation as it was sold politically, but a lose-lose situation.
The source of the continuing difficulty is that the replacement rate for unemployed people in both East and West Germany, thanks to rigidly regulated labor markets, is extremely high.
SCHOLES | Germany made some very bad mistakes in the 1990s, especially in the banking sector. Today, the banking system is in very bad shape because of the high price paid for foreign diversification and for supporting activities in Germany, such as the huge expansion of Deutsche Telekom and of Daimler Mercedes-Benz in acquiring Chrysler and so on. As a result of these investments that have gone sour, a lot of the system is now very weak.
The cost that Germany paid to bring about the euro is underestimated. Germany was the strongest nation, as far as debt rates were concerned. And then they brought the weaker economies of Italy, Spain, Ireland, and even France, to some extent. In effect, their credit was supporting all the credit of the rest of Europe.
Under the European Monetary Authority, Germany lost control of its money supply. It needed to increase money and reduce interest rates in Germany and was precluded from doing that.
If you look at the difference in the implied real rates in Europe versus the US, you would be shocked to see how high they are in Europe relative to the US, inflation-adjusted.
Germans needed a more expansive monetary policy, which they could not have because they signed the "stability pact" for Europe, which says that a country cannot have a deficit of more than 3 percent of GDP.
When you have a recession, as in Germany today, and the government has to cut expenditures to maintain the stability pact covenants exactly at the time when revenues are falling, then you lose control of fiscal policy as well.
So as a result of this, there are now so many "off-balance sheet" financings going on in Germany and Europe that it makes Enron look like an accounting saint.
Consumption is also collapsing because there is a realization by the population that the wonderful social programs that Kenneth Arrow alluded to are not sustainable.
When you put it all together, the outlook is grim. You cannot have stagnant population growth, have the younger population pay huge amounts for the older people to vacation in Barcelona and have all those wonderful social programs. The system does not hold together without either the growth that sustained it before the 1990s or the ability to go deeper into deficit. Something has to give.
Like Japan, Germany and the rest of Europe are going to have to restructure their pension systems. These system are no long sustainable just when they are needed—as the population bubble grows older.
MILKEN | What does all this mean for Britain and the rest of Europe?
BECKER | On Britain I would say: Do not join the euro. Yes, it is great for Britain to be part of the European Common Market, which it is, presently. That has been a great boon for Europe because people and goods and capital can move freely across the European community. The integration of Central and Eastern Europe will make it even bigger.
But all that is independent of whether Britain should join in the European community with the euro. And more so, I am not as worried about the euro as I am about having policy dictated out of Brussels.
The trend in Europe is toward more centralized government. The desirable trend, in my judgment, is, as much as possible, to decentralize decision-making, particularly in as heterogeneous a set of economies as you have in Europe.
ARROW | Economists like Milton Friedman objected from the outset to the idea of the euro on exactly the grounds that have come to pass—namely, what are called "idiosyncratic shocks." If a problem arises in Germany and other parts of Europe are booming, you cannot have a monetary policy which is separate for each circumstance. You are going to have the same monetary policy.
If, in addition, you restrict the fiscal policy—as the "stability pact" does—then you really have no way of handling a local situation. The obvious answer, though not a panacea, is a flexible exchange rate mechanism, although it has disadvantages because it invites speculation.
The British are probably well-advised not to join in.
SCHOLES | For a currency bloc of any form to work, human beings must be able to move freely among the various regions of the bloc. Capital mobility also has to be very easy, because that is the way things equalize at the margin.
Still, human capital does not move as readily in Europe as it might in the US. When, for example, we had economic difficulties in Detroit in the 1980s a lot of our human capital moved to the South, just as earlier in American history they had moved north. Until Europe has that kind of fluidity of movement, the currency bloc will have problems.
MILKEN | Some developing countries are concerned about the enormous growth of the manufacturing base in China and the pressure it is putting on other parts of the world. China could grow at 6 to 8 percent a year at least for the next 30 years, and at some point, its economy would be larger than the US and Europe combined.
Is China’s growth creating opportunities for the rest of the world or creating more challenges for the rest of the world?
SCHOLES | China’s GDP at the current time is only 10–15 percent of the US GDP. So, it will take a long time to catch up. And though still substantial, the growth rates are likely to be less than the official Chinese figures suggest.
But let’s be wary. Growth is a statistic that registers winners. not losers. And the public enterprises in China are in very bad shape. Most state-owned enterprises are essentially losing money or bankrupt. So the growth is negative in those activities, especially in terms of the waste of resources. The losses in the state enterprise sector will someday roll back to the financial institutions and we may see a banking crisis like we see in Japan today.
If you do not account for those cases where you have the write-offs your growth projection can be very much inflated.
And no economy, in my view, can grow at 6 to 8 percent a year for 30 years. By that theory of compound interest, as you said, China would be the largest economy in the world. But it is highly doubtful.
BECKER | There is a great deal of concern by business globally about the growth in the manufacturing output of China, which has been spectacular. Even though their figures significantly overstate, as far as one can tell, the actual rate of growth has been substantial—there is no question about it.
The Chinese are mainly competing against other low-cost producers of the world. So the major countries that they are taking business away from, so to speak, are the Malaysias, the Indonesias and the other cheap producers of the world, who now see China being more productive and cheaper. And therefore, China’s expansion in textiles, in toys, in a lot of the sort of lower-skilled products are growing substantially. Those who are benefiting are mainly the consumers in the US and other countries who are importing these goods.
China does provide, potentially, an enormous market. There is a lot of complementarity, rather than a zero-sum situation wherein if China does better, everybody else does worse.
If China does better, that is going to lead to an improvement in the well-being of not only consumers, but also many companies elsewhere in the world.
The potential market in China for educational services, for example, is enormous. It has been estimated that if they tried to produce as many university students relative to their population as the US, it would take the building of 10,000 universities with 10,000 students per university. They are not going to do it that way. They are going to do it in other ways, presumably, in part, by importing their educational infrastructure. The same scale of a market is there, for example, for the automobile industry.
China is also importing huge amounts of capital, so many Japanese, American and European companies are setting up an extensive financial network there.
So, the growth of China is going to harm some companies and some industries, but it is also going to benefit others. On the whole, US consumers and the US economy are going to benefit from the growth of China, rather than be hurt by it.
ARROW | The complementarities of trade with China are rather remarkable. I’ve seen men’s jackets designed in Japan, with one part put together in China and the sleeves in Malaysia—and it probably said "Made in Italy" on the label when it was sold.
However, this 6 to 8 percent growth cannot continue. It never has, anywhere before. If I may use an old Marxian expression, there are some real contradictions in the system that can only be overcome at a price.
One of the big problems is the role of the state-owned enterprises. They are not shrinking rapidly, only relatively, because the rest of the economy is growing. But the pressure to keep on supporting them is immense. If you look at investment figures, a large amount of investment is going into these moribund dinosaurs.
Now, I do not doubt that eventually the money being made in low-end textiles is going to invested in iron and steel and competitive value-added industries, but that is going to take a long while. At some point on this long march, the oligarchic political structure that is so out of line with the economy is going to have to break. At some point the political allocation of resources to maintain Communist Party legitimacy is going to conflict with the demands of the new economy.
Also, as we have seen in Japan and elsewhere, prosperity is self-defeating. Real wages raise. The comparative advantage in textiles and low-wage electronics goes down. It has happened to every country, and there is no reason for it not to happen in China.
IV. Two Worlds
MILKEN | Fifteen percent of the world’s population has 85 percent of the world’s economy. Eighty-five percent of the world’s population has 15 percent of the world’s economy. The issue of terrorism, AIDS, SARS and others disease compels us to recognize how small our planet is today.
If we take as a given that quality of life or prosperity in the developed world is highly dependent upon opportunity for prosperity for all the people on the planet, what are the two or three things that you could suggest that we have learned from history that we might be able to apply in the future?
SCHOLES | Changing the world begins at home. Infrastructure—not just physical but financial and legal —is very crucial. Decisions over what infrastructure to set in place will affect everything from property rights to the ability to make long-term investments.
If you have no rule of law, then investments are going to be very short. If you have the Yakuza or the Mafia in control, everything is going to be just a spot transaction. There can be no sustained growth or development in such an environment. So creating an environment of rule of law with all that implies, including property rights, is the first critical element.
The second critical element is not only general education—especially of women—but specialization. A country needs to figure out what it is most productive at doing and then develop that capacity.
India has come to life in certain regions because they have education, they have computer programmers, and can add a lot of wealth by specialization. But if you have specialization you must also rely then on the government to hedge country risks as a whole because, if you specialize, your country is subject to shocks from the global marketplace changing.
The US is diversified. We have many activities. If some industries are in bad shape, other industries are not in such bad shape. And it creates an ability for us to survive. So countries have to understand how to hedge their risks by paying attention to risk management.
BECKER | If you look at the degree of world inequality, not across countries but across individual families, then you find much more optimistic developments in the last 30 years.
The Columbia University economist Javier Salla-Martine has calculated world inequality and income on an individual family basis, rather than a country basis. And he finds significant declines in world income inequality over the last three decades.
Partly that is due to growth in China and India, but it is not entirely so.
Also, we are often too mesmerized by national income accounts which are an imperfect measure of people’s well-being—a highly imperfect measure. They leave out, for example, leisure. But they also leave out improvements in life expectancy.
In the last 40 years, the poorer parts of the world’s life expectancy has improved more rapidly than the richer parts of the world. Along with a couple of colleagues, I have made an adjustment to national income accounts by putting value on the improvements in life expectancy, using what economists call "Willingness to Pay" or "Value of Life Estimates."
We did this for different countries to see if we would get considerable convergence. We indeed found significant convergence after we adjusted a national income account to include the improvements in mortality.
The fact is that the poorer parts of the world have benefited enormously lately, in good part from technologies developed in the rich parts of the world. Their life expectancy, while lagging still, has improved and narrowed the gap.
MILKEN | In the last 50 years, life expectancy has increased about 10 years in the wealthier countries and about 20 years in the poorer countries. The gap today, thus, is about 10 years difference.
BECKER | So, there are lots of bad things that are happening, but there are encouraging signs as well.
ARROW | Even by conventional measures, there has been some convergence—and this after a century of increasing divergence. Clearly, a reversal of the historic trend has taken place over the last 20 years or so.
This is not universally true, of course. Sub-Saharan Africa is a disaster area, where things are getting worse in virtually every dimension.
As for how to close the gap further, the question of the infrastructure in a broad sense—social, cultural and legal—is certainly important. I think the responsibility of the developed countries is not entirely ended by that question, however. I am thinking particularly of trade. Protection, for agriculture, particularly, in the most advanced countries—and I mean all of them—Japan, the US and Europe—is really a very serious block. It impedes a significant possibility of export earnings for many of these countries, which would be a big kick- start in their development, particularly for Africa.
So, while the poorer countries have to reform their own structures, the rich nations also have plenty of responsibilities to fulfill.