DAVOS – The future of the global economy will depend greatly on whether President Barack Obama launches a comprehensive and coherent set of measures, and on how successfully he carries them out. How the Chinese, Europeans, and other major players respond will be almost as important. If there is good international cooperation, the world economy may start climbing out of a deep hole by the end of 2009. If not, we will face a much longer period of economic and political disorder and decline.

There is no way to reestablish economic equilibrium in one fell swoop. Instead,  the economy must first be pumped full of money to make up for the collapse of credit; then, when credit begins to flow again, the liquidity must be drained from the system almost as fast as it was injected. This second operation will be both politically and technically more difficult than the first: it is much easier to give money away than to take it back. It is all the more important that stimulus packages be channeled into relatively productive investments. The bailout of the motor industry ought to be the exception, not the rule.

The Dollar

The effort to pump the American economy full of money will run into difficulties on two fronts: the exchange rate and interest rates. The dollar came under pressure early in the current financial crisis, but staged a strong recovery as the crisis worsened. The dollar’s strength in the latter part of 2008 was due not to an increased desire to hold dollars but to increased difficulties in borrowing them. European and other international banks had acquired a lot of dollar-denominated assets which they habitually funded in the interbank market; as the market dried up, they were forced to buy dollars. At the same time, periphery countries held a lot of dollar-denominated obligations which they had to repay when they could not roll them over. Russia and East European countries on the periphery of the euro were tied much more to the euro; but when the Russian market collapsed, the effect on the dollar was the same, because the Russian central bank had overbought euros and had to sell them to defend the ruble.

The trend was temporarily reversed at the end of 2008 when the Federal Reserve lowered interest rates to practically zero and embarked on quantitative easing. The euro staged an explosive rally, but the rally was short lived because the eurozone developed its own internal difficulties. Widespread riots in Greece drew attention to the plight of the Southern Tier countries— Spain, Italy and Greece— and of Ireland. CDS rates for these countries rose, their credit ratings were lowered and the yield spreads on their government bonds versus Germany widened to an alarming extent. The euro headed lower right from the beginning of 2009 and it was even outpaced by sterling.

Going forward the fact that Germany and the European Central Bank hold a different view of the problem confronting the global economy from the rest of the world is liable to cause wide swings in exchange rates and hinder the recovery. The ECB operates under asymmetric guidelines: it is constitutionally obliged to be concerned only with maintaining price stability, not full employment; Germany still lives with the memory of the Weimar Republic’s runaway inflation, which served as a prelude to the Nazi regime. Both considerations militate against fiscal irresponsibility and unlimited money creation.

This should favor the euro as a store of value, but the internal tensions within Europe work in the opposite direction. The fact that there is no Europe-wide mechanism for protecting the banking system and each country has to act on its own raises doubts about their ability to do so. Is Ireland’s credit good enough? And can the ECB accept the government debt of Greece as collateral beyond certain limits? The foundations of the Maastricht Treaty are shaking—not to mention the difficulties that the United Kingdom and Switzerland are facing in protecting their overgrown banks.

As national regulators seek to protect their own banks, they may hurt the banking systems of other countries. For instance, Austrian and Italian banks are heavily exposed in Eastern Europe; the Royal Bank of Scotland which is now majority owned by the British government does the bulk of its business abroad while a significant portion of UK housing is financed by foreign banks. Eventually the various national authorities will have to protect each other, but it is only a common danger that will force them to do so. 

The owners of wealth may increasingly turn to the yen and gold for safety but the may run into resistance from the authorities—sooner in the case of the yen than gold. And there will be a tug of war between those who seek safety and those who need to use their reserves to save their businesses. With all these contradictory forces at work we can expect wild currency fluctuations.

Interest Rates

The way out of a deflationary trap is to first induce inflation and then to reduce it. That is an intricate operation and success is far from assured. As soon as economic activity in the United States revives, interest rates on government bonds are liable to shoot up; indeed, the yield curve is likely to steepen in anticipation. Either way, a rise in long-term interest rates is liable to choke off the recovery. The prospect of the greatly increased money supply turning into inflation is likely to lead to a period of stagflation. That, however, would be a high-class, desirable outcome because it would avoid prolonged depression.

It is difficult, but not impossible, to imagine the U.S. economy growing at a rate of 3 percent or more in the decade ahead. The United States has been running a chronic current account deficit, which exceeded 6 percent of GDP at its peak. That will disappear, and it will leave behind a heavy burden of foreign debt that will be further swollen by the budget deficits of the next few years. Consumption as a share of GDP has to fall. The financial services sector, which has been the fastest growing segment of the economy, will shrink. With baby boomers retiring in increasing numbers, demographic trends have turned unfavorable. All these are negative influences. What is to be expected on the positive side? More equitable income distribution, both domestically and internationally. Better social services, including education. A constructive energy policy leading to large-scale investments in alternative energy and energy saving. Reduced military expenditures. Faster growth in the developing world providing better export markets and investment opportunities. But even with the best policies, domestic growth is liable to lag behind the global economy.

China

What China does will have almost as much influence as President Obama on the future of the global economy, and Chinese-American relations will be the most important bilateral relationship in the world. China has a tremendous interest in the prosperity of the global economy. Obama can build on this in reconstructing the international financial system, but it will require great tact and foresight on both sides.

The emergence of a new world power is a dangerous process. Twice it has led to world war in which the emergent power was defeated. China has to go out of its way to make itself acceptable if it wants to be accepted as a world leader. It has adapted the doctrine of harmonious development, which is the right approach, but it also has other doctrines, notably those relating to Taiwan and Tibet, that work in the opposite direction. Due to the erroneous policies of the Bush administration and the bursting of the super-bubble, China has gained too much power too soon.   For a constructive partnership, both sides will have to lean over backward. President Obama has to treat China as an equal partner and China has to accept continuing American leadership. That will not be easy for either side.

China has much to lose. It is not a democracy, and there is no established routine for changing governments. Failure to achieve a satisfactory growth rate—generally defined as 8 percent per annum—could lead to political turmoil, and political turmoil in China would be disastrous for the world. Fortunately, China has developed a method of elaborate consultations that, while not democratic, do give the various interest groups involved a voice in determining policy. The main drawback of the consensus-building process is that it is slow and cumbersome, and there is a danger is that the Chinese leadership will not move fast enough to counteract the sudden drop in the global economy. Here again, a strong lead from the new Obama administration could have a beneficial effect.

The Indian Subcontinent

India is more self-contained than China, and it should have less difficulty in maintaining its upside momentum. The Indian stock market has been harder hit than that of most countries, but its banking system, which is still largely in government hands, has been less affected. Remittances from the Gulf States will suffer and its outsourcing business will languish, but hopefully infrastructure investments, of which India has a great backlog, will continue apace. The macro-economic outlook is more favorable than for most of the world.

The greatest uncertainties are political, and they revolve around Pakistan, which is a failing state. Some elements in the military and intelligence services have been closely involved with terrorists, and there is a real danger that they may gain the upper hand. The November 26, 2008, terrorist attacks on Mumbai were brilliantly planned, timed, and executed. Coming before the Indian elections, it was meant to set India and Pakistan against each other, allowing the Islamist influence in Pakistan at least to survive or at most to gain control of the State.

The Bush administration allowed all the various players to be set against each other: Pakistan against India and Afghanistan; the military against the civilian government within Pakistan; Nawaz Sharif against Asif Ali Zardari, within the civilian government—not to mention the various tribes that have been armed by the military in order to fight the Pakistani Taliban fighting each other. The task of the Obama administration will be to bring the various factions together to fight the common enemy, the people behind the terrorist attacks on Mumbai.

The problem of Pakistan is closely interlinked with the problem of Afghanistan. The American forces invading Afghanistan were originally welcomed as liberators, but NATO got involved without a proper plan of engagement, and after eight years the presence of foreign troops is no longer welcome. A New NATO plan ought to call for an orderly exit, but that is not possible while al Qaeda and the Taliban are gathering strength. Yet they cannot be defeated without the active support of the local population.

Three obstacles stand in the way of success: the drug war that sets the local population against the occupying powers; the existence of a safe haven in the tribal areas of Pakistan and; the Karzai government’s loss of legitimacy and popularity. The situation is not insoluble, but it will require extraordinary skill and perseverance to bring it under control..

The Oil-Producing Countries

The oil-producing countries have suffered a sudden reversal of fortune. Their surpluses have turned into deficits, and their sovereign wealth funds and currency reserves have suffered major losses. The Gulf States have been badly hit, because their private sectors, including some banks, were greatly overextended. Dubai was the world’s most spectacular real estate bubble and will have to be rescued by the deep pockets of Abu Dhabi.

But the oil producers’ woes are not necessarily bad news. Some of the major oil-surplus countries, notably Iran, Venezuela, and Russia, have been enemies of the current world order, and their wings are being trimmed. The decline in Iran’s capacity to sponsor political and terrorist movements in neighboring countries is already having beneficial effects. The political and security situation in Iraq seems to be stabilizing, and Syria seems to be more amenable to negotiation. The chances are good that Iranian President Mahmoud Ahmadinejad will not be re-elected in June 2009.

By contrast, Russia may become more of a menace due to the decline in oil prices. Under Vladimir Putin, nationalism has replaced communism as the country’s guiding ideology. The Kremlin is now using its control over natural resources to reestablish Russia’s position as a political power, enrich the rulers and ensure their own control over Russia, and to bribe and suborn the rulers of the former Soviet.  The various objectives mutually reinforce each other; together, they constitute the new order – a sham democracy built on petrol-patronage.

In the Putin regime, economic power has been concentrated in the hands of two groups: those who acquired property and those who take a slice of cash flows. By and large, the first group is more sophisticated and more Western-oriented: it keeps its money and its children abroad. The second group exploits the state’s arbitrary powers more directly. The first group was decimated by the financial crisis; the second was left relatively unscathed. The crisis reinforced the arbitrary powers of the state, as a large part of official currency reserves was spent to bail out and reacquire the first group’s assets.

This is important, because, as the economic outlook deteriorates and the Putin regime will no longer be able to satisfy people’s economic expectations, it is likely to rely more actively on arbitrary state powers. After all, the Kremlin is occupied not by the cautious bureaucrats of the Soviet era, but by buccaneers who were willing to take risks to get where they are. This may translate into military adventures abroad and repression at home.

Europe

Different European countries have reacted differently to the rise of a hostile Russia, influenced by their historical experience and their economic interests. Europe must resist the geopolitical challenge that Russia is posing, and it must be unified to have any chance of success. But a unified European policy must not be purely geopolitical, because Europe’s common interest would not be strong enough to override national interests. Russia could divide and conquer, as it is doing already. 

The key to Europe’s ability to neutralize Russia’s geopolitical advantage is to establish a unified energy policy, with a Europe-wide distribution network and a Europe-wide regulatory authority that has precedence over national regulators. This would deprive Russia of its ability to play one country off against another, because a concession granted to one national distributor would immediately become available to customers in all the other countries.

It no less necessary to continue promoting the rule of law, international cooperation, and the principles of open society, mainly by reforming the international financial system and by paying special attention to Russia’s near-abroad. Ukraine, in particular, is in a perilous state, but financing public works that would create jobs in Eastern Ukraine, where the steel industry is in distress, could make a major difference both politically and economically. Georgia must be helped to recover from the damage inflicted by the Russian invasion, but help should be contingent on the Saakashvili government observing the principles of open society. Russia cannot be helped directly because of its excessive reliance on arbitrary state power, but when Russia sees progress in international cooperation, particularly with China, it will not want to be left out in the cold.

The financial crisis and its aftermath will be a period of testing and, one hopes, development for the European Union’s institutions, particularly its financial institutions, which are relatively new. The EU has a common currency and the ECB, but it does not have a common fiscal policy or treasury. This shortcoming has become increasingly evident and it may lead to a breakup of the eurozone. But belonging to the eurozone proved to be very valuable—Greece is hurting less than Denmark although its problems are much greater. Therefore the odds favor that the euro will emerge from the current crisis with the ECB given greater powers over the banking system.

The Bush administration distinguished itself by driving a wedge between “old Europe” and “new Europe.” It is to be hoped that the Obama administration will adopt the opposite course. The world badly needs a more united Europe, both politically and financially.

The Developing World

A few countries like Brazil and Chile are reasonably well positioned to engage in countercyclical policies on their own with only a light assist from the IFIs. But most of the rest of the developing world is heavily dependent on the initiatives outlined in the previous chapter. In the absence of a radical international initiative, they face a very grim future. Countries like Pakistan, Egypt, Morocco, and Haiti have already experienced food riots. Others, such as South Africa and Turkey, suffer from serious power outages. Mexico has a serious security problem because of drug trafficking. As the economic situation deteriorates, the chances of civil unrest rise.

The collapse of credit in the global financial system is having an even more devastating effect on the countries of the periphery than those at the center.  Credit lines are withdrawn, maturing loans cannot be rolled over and trade finance has dried up. Hopefully, the leaders of the world recognize that it is in their own enlightened self-interest to come to the rescue of the developing world. The attraction of the SDR donation scheme is that it does not impose any direct costs on donor countries. All they have to do is vote for the creation of SDR and then pass on the benefits to less-developed countries. I hope they will rise to the occasion.