US recovery: A new “Phoenix Miracle”?

Guillermo Calvo, Rudy Loo-Kung 12 April 2010

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Examination of systemic financial crises in emerging market economies reveals a surprising phenomenon. As figures show, even though the proximate cause of these crises is a systemic “sudden stop” (of capital inflows), output recovery occurs without an equivalent increase in investment or domestic credit (IMF 2010).
This “Phoenix Miracle”, as defined in Calvo et al. (2006), also holds for the US recovery following the Great Depression – except that the latter exhibits larger and more protracted output loss than the average emerging market in Calvo et al. (2006) sample.

Recovery from the global crisis

The recent subprime crisis has several analogous characteristics with crises in the typical emerging market – although output decline in the US has been significantly smaller, and the duration of the crisis promises to be shorter. But there are also interesting disparities. In the typical emerging market crisis, recovery is accompanied by a spectacular export growth, while in the US government expenditure has taken the lead.

Figure 1 shows the strong resemblance existing between average emerging market crisis and the subprime recession in terms of GDP. The dotted line is the consensus forecast for the US, showing that analysts expect faster output recovery for the US.1

Figure 1. Real GDP in the average emerging market collapse and the US subprime crisis

In Figure 2, we can observe that domestic credit – defined as credit to the private sector from domestic banks – also shows weak recovery in the US, if at all.2 Furthermore, in both the US and the average emerging market, investment fails to accompany output recovery. Therefore, at first examination the present recession qualifies as another Phoenix Miracle.

Figure 2. Systemic collapses in emerging markets crises vs. US subprime crisis

Notes: Solid lines depict GDP series (measured in the left axis) and dashed lines represent the series specified in the right axis. Black lines correspond to the US while the red lines, to the average for emerging markets. All series are normalised to 100 at the date of the peak in GDP. The 21 episodes considered are those identified in Calvo et al. (2005) as systemic collapses – both mild and deep – for which quarterly data is available. See the appendix for a complete list of episodes and data sources.

Another parallel is worth highlighting, namely the adjustment of the private sector current account, defined as the country’s current account minus fiscal deficit. As shown in Figure 3, the private current account in the typical emerging market crisis improves by around 5% of GDP over the whole Phoenix Miracle cycle. In the US, the equivalent adjustment represents 8.6% of GDP. This truly wrenching adjustment would be hidden from view if one focuses exclusively on the US current account, for which the adjustment was only around 2% of GDP. These facts suggest that, left to its own devices, the private sector may have plunged into much deeper recession, if not an outright Great Depression mark 2.

Figure 3. Selected variables: systemic collapses in emerging market crises vs. US subprime crisis

Average emerging economy vs US

Notes: Due to data availability, we present annual data for the average emerging market crisis. Solid lines depict GDP series (measured in the left axis) and dashed lines represent the series specified in the right axis. The private current account balance is calculated as the difference between the overall balance and the general government budget surplus. See data appendix for details.

Export recovery or fiscal expansion?

Things begin to look quite different in regard to trade and government expenditure. The average emerging market crisis exhibits sharp real currency devaluation while in the most recent data from the US shows a trendless real exchange rate after a transitory spike around the end of 2008. The difference in export performance is striking. From peak at the start of the Miracle episode in the fourth quarter of 2008 to the latest available data for the final quarter of 2009, US exports fell by 5%, while over an equivalent period the average emerging market’s exports increase by 6%. Over the entire Phoenix Miracle episode – from peak to recovery – exports for the average emerging market increase by a staggering 20%.

Government expenditure shows the opposite pattern. From peak to the fourth quarter of 2009, US general government consumption increased by as much as 6%, while the typical emerging market government consumption shows a neutral trend. Interestingly, though, over the entire phase the average emerging market exhibits a rise in government expenditure of about 4%, but the increase takes place from trough to recovery.

The main different between the average emerging market crisis and the US subprime crisis is the spectacular rise in exports in emerging markets – taking the full Phoenix Miracle period into consideration. An explanation for the different expenditure pattern is that emerging market crises occurred during the “Great Moderation” period in which advanced economies were able to absorb emerging market current account adjustment through higher imports. Furthermore, fiscal stimuli in emerging markets – especially, from peak to trough – were not easy to implement (notably, compared to the US) because emerging market governments were themselves also subject to a credit crunch. Moveover, the export channel is mostly closed to the US given that the subprime crisis has a global character.

Higher multiplier or export growth?

Is the average emerging market blessed with a high multiplier, or did export growth get much of the job done? In order to get a sense about orders of magnitude, let us assume that exports are the main exogenous (with respect to income) factors of recovery, and that the effect of export expansion can be measured by the trough to recovery GDP growth (heroic assumptions, indeed). Then, the export multiplier would be 1.5, which, interestingly enough, is close to the numbers bandied about by the US administration and dyed-in-the-wool Keynesians. Therefore, this suggests that emerging markets are not blessed with an unusually high multiplier. Exports and, later, government expenditure are the main exogenous demand-side factors associated with recovery. If similar parameters are applied to the US, then the expansion of total general government expenditure would explain a large chunk of the recovery. The 6% rise in total government expenditure in the US (which is about 30% of GDP) would bring about a fiscal stimulus of about 1.8% of GDP – which multiplied by 1.5 results in a 2.7% increase in GDP relative to trough, and represents around 70% of the increase in GDP needed for recovery. However, sustainability of recovery is arguably more of an issue for the US than in the average emerging market crisis. This is so, because the US fiscal stimulus is supposed to be temporary. Moreover, if the stimulus lasts longer than planned, public debt might skyrocket with deleterious effects on output growth and inflation.

A double dip recession?

In contrast, the typical emerging market’s recovery was associated with export expansion that was only interrupted or reverted much later (during the subprime crisis). These considerations justify the concerns some people have about double-dip recession in the US. The latter could be prevented, for example, if the effects of credit crunch are offset by the higher liquidity pumped in by the Fed, and investment also rises from the ashes. (It is hard to be enthusiastic about exports, given Europe’s troubles and the size of the emerging markets, even if China acquiesces in appreciating its currency.)

Different flight paths

Phoenix Miracles do not hit every country alike. Figure 2 shows, for example, that in the average emerging market the real exchange rate, a central relative price, does not return to its pre-crisis level. Actually, at recovery the typical emerging market real exchange rate is more than 30% higher than its pre-crisis level. This outcome is consistent with a situation in which full employment is achieved but the average emerging market faces tighter international credit conditions. The resulting contraction in aggregate demand calls for a lower current account deficit and a higher real exchange rate. Moreover, if exports are relatively less labour-intensive, real wages are likely to fall. All of these implications are borne out by data (see Figure 3). Thus, the bird rises from the ashes but its plumage’s distribution is unlikely to be the same.

Unevenness of recovery may also be a feature in the US. As Figure 3 shows, the real wage has recovered its pre-crisis level but unemployment has doubled; unlike the typical emerging market, in which real wages plummeted and unemployment only rose slightly. This suggests that the equilibrium US real wage may be lower when the Phoenix Miracle cycle comes to an end, which would be another parallel with the average emerging market. Lower real wages may be the natural outcome of retrenchment in labour-intensive construction sector, for example. However, as in emerging markets and the Great Depression, falling real wages may have serious political consequences, both nationally and internationally such as a new wave of protectionism.

Financial market roots

There is no doubt that the subprime and the emerging market crises reflect shocks that originate in the financial market. Our discussion has emphasised aggregate demand channels in the recovery, but this is a far cry from saying that stimuli to aggregate demand fix the financial problem. The evidence presented here does not support that.

At best the evidence suggests that increasing government expenditure can help to absorb the slack left by the contraction in private sector aggregate demand. This may help cushioning the financial shock by slowing down relative-price adjustment and, in that manner, further preventing massive bankruptcy. On the other hand, this may interfere with adjustment to new equilibrium, and make the economy more dependent on government expenditure, with severe consequences for future growth and innovation.

Even the export-driven recovery in the average emerging market is not devoid of financial considerations. Economies like Korea and Thailand with a long record of high growth found themselves bereft of export credit in the 1997 crisis, which threatened to paralysing exports despite large currency devaluation, which tremendously increased their international competitiveness.

Recovery of trade credit required international financial cooperation and, in some instances, selling domestic assets at fire-sale prices to multinational corporations with access to the credit market. This had the virtue of restoring the credit channel and increasing the chances of growth sustainability.

Will government expenditure have similar healing effect on financial intermediation? We doubt it, but only future can tell.

References

Adrian, T. and Hyun Song Shin (2009), “Money, Liquidity, and Monetary Policy,” American Economic Review, 99, 2, pp. 600–605.
Calvo, G., A. Izquierdo and E. Talvi (2006), “Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crises,” NBER Working Paper No. 12101.
IMF (2010), “World Economic Outlook Update A Policy-Driven, Multispeed Recovery”, IMF, 26 January.

Appendix: Systemic collapses in emerging economies

Data Sources

  • National accounts: Series on GDP, investment (gross capital formation), exports and government final consumption expenditure (all at constant prices and seasonally adjusted) were taken from national sources.
  • Real credit: Credit to the private sector deflated by the consumer price level. Source: IMF IFS (lines 22d and 64zf, respectively).
  • Real exchange rate: For emerging economies, the (CPI-based) real exchange rate is calculated vis-à-vis the US dollar. For the US, we use the real effective exchange rate published by the IMF IFS.
  • Wages: Nominal wages deflated by the CPI. For emerging economies, data on nominal wages was obtained from International Labour Organization (ILO) database (complemented with data from CEPAL, Asian Development Bank, IFS and Central Bank databases). For the US, wages and salaries are taken from the Bureau of Labour Statistics.
  • Unemployment rate: Total unemployment rate. Source: World Bank’s World Development Indicators (WDI), except for the US, whose data is from the Bureau of Labour Statistics.
  • Current account: Current account balance. For emerging economies, data was taken from the IMF’s World Economic Outlook (WEO) database. US data comes from the Bureau of Economic Analysis.
  • Private sector current account: This is calculated as the country’s current account minus the general government budget balance. Data for emerging economies was taken from the IMF’s World Economic Outlook (WEO) database. Data for the US comes from the Bureau of Economic Analysis.
     

1 As in Calvo et al (2006), we define “peak” as the time when output reaches its maximum value before a trough, and “recovery” as the time when output recovers its pre-crisis peak level following the collapse.
2 Bank credit is not very relevant for US since there are other more important credit sources However, over the sample considered, a broader measure of credit in the capital markets like the one considered by Adrian and Shin (2009), shows a similar pattern. The initial rise may have been linked to customer credit lines that were activated in the first stages of the subprime crisis. However, it is clear that banks eventually failed to fill the gap left by the contraction in asset-backed credit lines.

 

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Topics:  Global crisis

Tags:  Great Depression, global crisis, export-led recovery, fiscal expansion