Over the past year the global economy has been plagued by the confluence of three major shocks: volatile commodity prices, a serious downturn in the housing markets of several advanced economies, and most recently the ensuing financial crisis. The shock waves emanating from these three crises, most acutely from the financial crisis in the United States, have yet to play out completely. But it is becoming increasingly clear that the world’s economic and financial systems are about to undergo dramatic change.
In the United States and Europe, massive credit growth and high-risk lending over the past eight years fueled an unsustainable rise in asset prices. The swift re-pricing of risk for assets related to U.S. subprime mortgages over the past year created a liquidity crunch in the U.S. and European banking systems, exemplified by the freeze in interbank lending these past few months. So far, the effects of the credit crisis are more pronounced in the advanced economies of the United States, Europe, and Asia than in the major emerging economies.
The International Monetary Fund forecasts a reduction in global growth to 3 percent in 2009 from 5 percent in 2007. Growth in advanced economies is likely to be almost zero at least until the middle of 2009; in the United States it is forecast to be flat or even negative for the remainder of 2008 and early 2009. Growth in developing and emerging economies is projected to slow to 6.1 percent in 2009 from 8 percent in 2007.
Avoiding an even worse scenario—a long-lasting full scale global recession—depends on the extent to which international markets are able to reverse the tightening of credit, resist pressure on individual currencies, maintain domestic demand, and restore confidence among financial market participants.
In the United States, the Bush administration’s new $700 billion financial rescue plan did not prevent the house of cards on Wall Street from tumbling down. The woes of an already slowing economy have been compounded in the past few weeks by failing financial institutions and the ensuing credit crunch. And a total loss of 760,000 jobs in the first nine months of 2008, stagnating wages, and declining home values have done little to bolster consumer confidence.
In Europe, measures from nationalizing banks to the issuing of loans by central banks—alongside private-sector moves to tap the financial resources from Asian and Middle Eastern investors—have helped troubled banks in the United Kingdom, France, Germany, the Netherlands, and Belgium, among others. In the face of the current financial crisis, the 15 countries that use the euro have agreed to a European accord pledging to prevent banks from failing rather than adopting a piecemeal approach.
In contrast, Japanese banks have maintained relative stability so far. The bursting of Japan’s economic bubble in the 1990s, which was also sparked by bad real estate loans, taught the world’s second-largest economy a lesson or two. Still, Japan is not immune to significant stock market fluctuations and to a downturn in manufacturing exports driven by a drop in demand from the United States.
Across most of the developing world, volatile commodity prices have had significant and serious consequences. These countries have so far shown resilience in the face of the current financial crisis, but the pressing question is nonetheless whether they will continue to do so. These nation’s stock markets have in recent days plunged significantly, attesting to nervous investors worldwide. And the current state of affairs is likely to affect capital inflows as foreign institutional investors in need of liquidity withdraw rather than invest their capital.
China and India, however, which together constitute approximately 2.5 billion of the world’s population, boast two of the world’s biggest and most dynamic emerging economies. Nonetheless, after several years of robust expansion, the growth rate in China and India is expected to decrease by approximately two percentage points. Still, China is expected to maintain a high 8 percent growth rate, and India 7 percent. India is quick to note that China is its largest trading partner, signifying that it is not as reliant upon the advanced economies of the United States and Europe hardest hit by the financial crisis.
China has more than tripled its share in gross world exports between 1990 and 2007, and is poised to surpass Germany as the world’s largest merchandise exporter. Domestic consumption in China and India also continues to rise, suggesting that they are becoming less dependent upon demand from advanced economies.
The financial crisis has inspired widespread speculation of a shifting balance of power away from the United States and other advanced economies of Europe toward the major emerging economies. Whether this is indeed the case is yet to be seen, but that emerging economies such as China and India are becoming critical players in the global economic game is clear.
The United States’ already bruised reputation from the protracted war in Iraq, its resistance in signing the Kyoto Protocol, and overall apathy in world affairs is only hurt further by the flagrant lack of oversight and push for deregulation leading up to this financial crisis. Leaders worldwide have been forthright in their reproach of the “American roots” of the financial quagmire.
Indeed, World Bank president Robert Zoellick and leaders at the U.N. General Assembly have called for the inclusion of major developing countries, among them India, China, Brazil, Saudi Arabia, Mexico, and South Africa, in a new multilateral group expanding the current Group of 8 industrialized nations. The G8 now consists of Canada, France, Germany, Italy, Japan, Great Britian, the United States, and Russia.
This drive to construct a more inclusive and effective global governance framework on the one hand reflects a loss of trust in America’s ability to lead, but on the other hand provides a renewed opportunity for the next administration to engage with the international community and specifically the developing world to reclaim some of its lost prestige. The full magnitude and reach of the current financial crisis remains to be seen, but it will undoubtedly lead to changes in the global landscape as we know it.
Sabina Dewan is Associate Director of International Economic Policy at the Center for American Progress. For more on the Center’s policy proposals and analysis in this arena, please see the Economy page on our website.