Fundamentally Strong?

Barack Obama said it. Ben Bernanke said it. Manmohan Singh said it. It has become the mantra of politicians and policymakers around the world to assert that their economies are “fundamentally strong.”

But what does that mean? Is it just a palliative offered to the sick? In my opinion, it denotes two things: the hope that the economic cycle would turn up and the belief that the economy has sufficient means to get on a growth path again.

Of these, the first part needs no espousal. The economic cycle will definitely end – that’s why it is called a cycle in the first place. The more relevant questions are: how low will things get before the cycle ends and how long will it take to get back to the pre-crisis peak.

To measure the cyclical distance from peak to peak, there are several indicators that could be chosen. One is GDP per head, which is a “flow” concept of how wealthy people are. At an individual level, a person forced to take a lower paying job will wonder if he would ever earn the previous salary again. Taken in aggregate, the GDP per person is the same.

The other indicator could be a “stock” indicator, measuring the total wealth in the economy, held in the form of financial assets, property and other real assets. Staggering amounts of wealth have indeed been destroyed by the crisis, and I think it is going to take far longer for the wealth to be rebuil. Theoretically, the value of an asset ought to be the present value of the future income that it can produce. But many of the common assumptions for the pre-crisis asset valuation are now likely to be questioned. In particular, some valuations had been built on the expectation that the great moderation (the notion that economic growth and inflation have become less variable) would continue forever. Some others had been based on the cheapening of money that had occurred in the latter years of the Greenspan era. Both these are likely to be thrown out the window, at least in the medium term, until another cyclical bout of bullishness takes hold. Without those assumptions, which have been proved to be overly optimistic, the previous asset values have no justification and are unlikely to recur.

What about the second part of being fundamentally strong – the idea that the economies have some underlying attributes that would make their people prosperous again? This is an argument that has some basis. Before we look at the future, let’s look back and exmine the three factors that had underpinned rising global prosperity. Over the long term, much of the economic prosperity had been derived from global trade. In the last 30 years, China’s emergence as the world’s factory had been another factor that had kept the global costs down. The emergence of computers as a productivity booster was the third factor.

In the future, when the economies start to climb back from the current hole, we can expect pretty much the same factors to drive growth. Global trade can continue for a long time, as well as a shift of production to low-cost countries besides China. To what extent information technology can be further milked for higher productivity is difficult to estimate. On one side, adoption of computers by low-cost countries can improve their productivity and benefit the globe through trade. On another side, more widespread use of smaller but specialized chips for different tasks can improve productivity everywhere. These can together continue to benefit the word.

Not all is lost. Although some of the irrational asset values may not recur (and to that extent, wealth has vanished), the world still has a few engines with which it can extract more prosperity.