by Rebecca
Cross posted from Newsneconomics

These are interesting times in global economics, especially from the policy perspective. And although there was a sense of global urgency across the G7 (Canada, France, Germany, Japan, Italy, UK, and US) and the G5 (Brazil, People's Republic of China, India, Mexico, and South Africa) late in 2008 and early in 2009, policy makers now face very different economic circumstances. The global downturn was (mostly) ubiquitous, but the upswing will not be. The G5 are likely to initiate explicit exit strategies before the G7, as growth, domestic demand, and inflation rebound first.

The downturn in the developed world was very severe, as illustrated by the sharp contraction of GDP of the G7 countries. And across the G5, some countries experienced similar declines, however given the nose-dive that was global trade, the economic resilience via expansionary policy in India and China has been rather remarkable. 

Domestic demand, underpinned by robust fiscal and monetary policy pushed auto sales forward in the G5 and simply offset some of the decline in retail sales in the G7 (see charts below). I used auto sales in the G5 as a proxy for retail sales, as I could not access a retail sales in India (not even sure they offer the statistic). Impressively, though, retail sales remained strong in the UK. Auto sales in China, Brazil, and India have been hot - the real question here is: what is the underlying demand for goods and services in these countries, especially in China.

Monetary policy - driving down interest rates in order to stimulate consumption via the credit markets - was very successful in the G5, but much less so in the ailing G7.

And finally, inflation has been quite resilient in some countries, notably in the UK and India. As such, the Bank of England has a real trade-off with which to contend: inflation (as measured by the CPI), 1.6% over the year, remains sticky and remarkably close to target, 2.0%. The Reserve Bank of India is seeing food prices drive inflation steadily upward. http://online.wsj.com/article/SB125439928727956013.html?mod=googlenews_wsjSome expect India to be one of the first emerging markets to start tightening (The Bank of Israel was the first).

There are a lot of question marks right now - the biggest is when central banks and fiscal authorities start to pull back. Especially in the G7, too early and one risks the feared W, but too late, and inflation becomes an issue.

Across the G7, rate hikes are unlikely to occur until well-into 2010, and maybe even 2011 for some. Across the G5, however, late 2010 is more likely an upper limit, however, some countries like Mexico are seriously struggling and policy will remain loose for some time. (See RGE Monitor Nouriel Roubini's latest, "Thoughts on Where We Are" - unfortunately, a subscription is required.)

Here are some charts to demonstrate what I was talking about. the recent drop in US bond yields has not been accompanied by a similar drop in European rates.
Consequently the spread between US and foreign bonds has narrowed and it no longer compensates foreigners for the currency risk they take when investing in the US.
The consequences are a weak dollar. Note the opposite happened when Reagan first
created structural deficits and the dollar had to weaken enough to create a large enough
trade deficit to facilitate the capital inflow. At that point we had crowding out but it worked through the dollar to crowd out the manufacturing sector rather then the interest sensitive sectors.



It is also working against the Euro as you see the it strengthen when rates spreads widen.

When the US made itself dependent on foreign capital inflows the world got a lot more complex and it was no longer possible to analysis monetary or fiscal policy as if the US were a closed economy. I worry that we are now starting to see the bear case that I have worried about for years when international capital flows prevent the Fed from easing when domestic considerations call for it. I'm not making a forecast, I'm just laying out factors that make the analysis much more complex and that need to be brought into the analysis.

Maybe it is what we need to revive the manufacturing sector, and will be what drives the economy over the next decade. Save-the-rustbelt would love this. But, it creates inflation and real income complications for the rest of us.

I probably is what will happen since Don Boudreaux at the Cafe Hayek blog just got one of his letters to the FT published where he praised the trade deficit. I just base my analysis on the thesis that he is usually wrong.


I realize these charts are simple and the real world is more complex involving covered interest rate difference, etc, but they are adequate to make the point.

Here are some charts to demonstrate what I was talking about. the recent drop in US bond yields has not been accompanied by a similar drop in European rates.
Consequently the spread between US and foreign bonds has narrowed and it no longer compensates foreigners for the currency risk they take when investing in the US.
The consequences are a weak dollar. Note the opposite happened when Reagan first
created structural deficits and the dollar had to weaken enough to create a large enough
trade deficit to facilitate the capital inflow. At that point we had crowding out but it worked through the dollar to crowd out the manufacturing sector rather then the interest sensitive sectors.



It is also working against the Euro as you see the it strengthen when rates spreads widen.

When the US made itself dependent on foreign capital inflows the world got a lot more complex and it was no longer possible to analysis monetary or fiscal policy as if the US were a closed economy. I worry that we are now starting to see the bear case that I have worried about for years when international capital flows prevent the Fed from easing when domestic considerations call for it. I'm not making a forecast, I'm just laying out factors that make the analysis much more complex and that need to be brought into the analysis.

Maybe it is what we need to revive the manufacturing sector, and will be what drives the economy over the next decade. Save-the-rustbelt would love this. But, it creates inflation and real income complications for the rest of us.

I probably is what will happen since Don Boudreaux at the Cafe Hayek blog just got one of his letters to the FT published where he praised the trade deficit. I just base my analysis on the thesis that he is usually wrong.


I realize these charts are simple and the real world is more complex involving covered interest rate difference, etc, but they are adequate to make the point.