Viv Davies interviews Michael Spence for Vox

April 2011

Transcription of a VoxEU audio interview [http://www.voxeu.org/index.php?q=node/6333] 

Viv Davies:  Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 6th of March 2011, and I'm in Washington D.C. at a conference hosted by the IMF on "Macro and Growth Policies in the Wake of the Crisis." Today I'm talking to Michael Spence, Nobel Laureate and Professor Emeritus of Management at Stanford University about global prospects for growth.

I began by asking Professor Spence whether he considered our understanding of growth has changed in light of the crisis.

Michael Spence:  I think the fundamentals that we have come to understand about growth since the work of Bob Solow are still kind of in place. We've known, you know, from watching developing countries and from even the experience in advanced countries, that a stable macroeconomic environment with reasonably predictable and low inflation is a conducive environment from the point of view of growth dynamics. And so, I think the main lessons of the crisis have to do with the maintenance of stability. I think of stability as a necessary but not sufficient condition for growth. But it is an important necessary condition and so a lot of attention is quite rightly being devoted to that.

What I'm trying to say is that the fundamental kind of, you know, the macroeconomic dynamics of growth are things that we've come to understand and I don't think the crisis changes that part of the learning process, we're still learning.

We certainly don't know everything we need to know about it. There's a whole lot of political economy questions in the area of the developing world that have to do with getting things started and so on that are important subjects of research and that's ongoing and I don't think that's fundamentally affected by the crisis.

The big surprise was how well the developing countries, the major emerging economies, did in the crisis both in terms of prepositioning and then their speed and the effectiveness of their reaction.

Now, they had an advantage, in that they didn't have as much balance sheet damage as we did. But they, but they probably, because of previous crises, you know, had pretty good positioning, relatively low external debt, relatively low overall debt, a lot of learning had gone on in terms of managing the macroeconomic side of their economies.

So, they weathered the storm well both in terms of reducing the magnitude of the downward dip, the transmission mechanisms, I think you know. I mean, the two main transmission mechanisms to the developing world, given that this was an earthquake with an epicenter in the U.S., were the withdrawal of capital because of damaged balance sheets in the advanced countries. And that caused sort of an immediate credit tightening and a whole bunch of other effects, you know, plunging exchange rates and so on. That, they handled extremely well.

The other one was that trade fell off the cliff, you know, for reasons that I think we still don't completely understand. I mean, way more than the decline in GDP and we'll probably get to the bottom of that in the next little while. But, it bounced back fairly fast and they responded differently to that reasonably well. China came in first with a huge amount of capacity for fiscal stimulus and they did it by investment.

But, other countries did a pretty reasonable job. And then, when trade came back reasonably quickly in 2009, these economies really have bounced back to pre‑crisis growth rates. The obvious question is, so they got through the crisis pretty well, can they keep it up if the scenario is that Europe and America and Japan sort of struggle along?

And the answer seems to be "yes." I think if we took another great, big dip--I mean, to calibrate how much independence they now have vis‑à‑vis, us--if we have a big downturn in Europe or America, I think it will hit them. So this isn't decoupling. But if we just struggle along, the combination of their size, their intra‑country, intra emerging market trade and the rising income levels, which means the composition of demand, is much more interesting and much closer to, you know, where their economies' supply sides are, I think they can probably keep this up.

Viv Davies:  And, what are your views on the current growth prospects for the U.S.?

Michael Spence:  So, there's a kind of question mark, you know, here. I've spent the last sort of six months trying to figure out what happened in the last two decades to the structure of the American economy. Because we were all talking about structural issues, but I didn't think I, at least, had a grip on it, and I'll tell you about that in a second.

My best guess, to give a straight answer to this, is that the economy will struggle up to a reasonable level of growth over the next couple of years. I think there's been a pattern of over‑optimism, right from the get‑go. The crisis was viewed as a cyclical event, whereas, in fact, it was a huge balance sheet hit. The growth assessments by markets and policymakers were too high. They didn't take seriously the kind of healing process and so on.

So I think we're probably going to have a pretty good year this year, and then, I think we're probably a little too optimistic about the longer term. The underlying thing that's hard to figure out, other than how we're going to deal with the budget problem, has to do with employment.

So let me give you the bottom line. I think growth and employment are diverging in the American economy. And the basis for that, in brief, this was the kind of research we were doing. So we went back 20 years, since 1990, and asked up to the crisis: Where did we create employment in the American economy? And the answer is we created it in a non‑tradable sector, pretty much all of it, 98% to be precise.

And the big non‑tradable sectors are government, health care, retail, construction, and hotels, restaurants, and food service. Yeah, I can think about those things, but maybe government isn't going to absorb all the incremental employment demands in the economy. Health care is at least a question mark.

And then, what's happening in the tradable sector is that some sectors, which are, wouldn't surprise you, their areas of comparative advantage in Europe and America are growing in employment and value‑added. The surprising ones are manufacturing. They're declining in employment and growing in value‑added. Value‑added, when you add it all up, is pretty close to GDP. I can't figure out a way to avoid this sort of technical term in describing it to people, but if you want to avoid double counting, you've got to use it.

And so, what's happening in the American economy is the lower value‑added parts of the tradable sector are moving away, and the higher value‑added parts are highly competitive and they're driving the growth. And these are correlated with things like education levels in terms of who's employed there. So I think what's going on in our economy, which is a little worrying, is that we'll probably get reasonably decent growth out of a combination of the non‑tradable sector and the competitive part of tradable sector, but we won't get enough employment out of it.

And when that sort of dawns on us and we realize it's a problem that's been… Well, the miracle in the American economy is that with no incremental gains in the tradable sector in employment, we didn't have an employment problem. And information processing and transactions automation that went with information technology was also labor‑saving.

So it, in principle, might have caused an employment problem because it's big enough, it runs across the entire input‑output table of the economy. In the face of that, we really didn't have an employment problem. But when you look closely, we didn't have an employment problem because government and health care contributed almost 40% of the 27 million jobs we created in those two decades.

So the question is, and I don't think that there's an obvious answer to it, but it's a question that's only beginning to be addressed: Do we really have an employment problem? Will employment come back with growth? And is it possible to continue to lose chunks of the value‑added chains in the tradable sector? And I think those are the question marks about future growth in America to which, frankly, none of us knows the answers. But that's the picture.

Viv Davies:  So you don't buy into this current idea of the "Great Stagnation" which suggests that rich countries like the U.S. have already captured the easy gains that could be made from education, land use, innovation, and so on?

Michael Spence:  No, I don't. I think that the underlying driving force of growth from what's come to be called the "endogenous growth theory" is that growth comes for a while from new frontiers, from deepening the capital base of the economy. But in the end, all of those things have diminishing returns, and in the end, it's innovation. And what endogenous growth theory does, did, was to go back to Schumpeter and sort of say, "Well, what are the incentives? I mean, why does this happen? At least, what is the economic component of the explanation of it?"

I've tried to write about this in my book a little bit. And I don't see any reason to think that in the advanced countries this process will stop. So, other things equal, meaning a stable macroeconomic environment, a fiscal situation that's in reasonable shape, there's a question mark about demographics because we're aging. But, I don't see any fundamental reason, why to expect a slowdown in growth.

Viv Davies:  I'd quite like to get your view on the issue of global imbalances, currency manipulation, whether you think targets for current account surpluses and deficits are a good thing and how you would envision encouraging countries not to run large surpluses.

Michael Spence:  Yeah, this, I think, is a learning from the past few years; the crisis kind of brought it to the fore. It's probably not a good idea for any country to run a big deficit, the current account deficit for a long period of time. And, I think the right way to describe the surplus thing is, it's sort of antisocial but it serves no strategic purpose to run a big surplus. It's sort of a mistake. Nobody wants to run a big surplus. And saving at a high enough level to cover the investment and having investment at high levels is strategically useful and important.

So, the good news is that the big surplus countries, for the most part, like China, they don't have any interest in running a big surplus. So, their interest and our interest in having them get it down, as long as they don't do it in such a way as to lose that growth. It’s a qualification that’s not normally applied, but if we had a choice between China getting their surplus down and having the growth get killed--meaning all of us outside, including the rest of the developing world--or keeping the growth up and having trouble getting rid of the surplus, you pick keeping the growth up for self‑interested reasons.

But they have the same interests as we do, meaning, they need domestic demand to drive growth, they have to shift more income to the household sector, they want the supply side to respond to the demand side. And, if too much of the demand side is investment driven by government and state‑owned enterprises, they'll run out of gas doing it that way.

So, our interests are pretty clearly aligned. So I was actually quite encouraged. I mean, I thought the discussion of exchange rates was sort of off base, not because they're unimportant, but because the discussion didn't acknowledge the structural underpinnings of these surpluses and deficits on both sides. On the American side, I mean the yuan could go down and down and it would have an effect, but it's not the answer on the export side. And raising the value of the yuan is not all of the answer on the Chinese side.

So, in the G20, when they started to talk, even though they haven't finished--I mean, they kind of got kidnapped or sidetracked by the quantitative easing discussion in November in Korea--but I think the discussion that there's a collective interest in sort of managing, over time, surpluses and deficits, is a kind of practical, sensible way to go.

Viv Davies:  I'd like to come back to the emerging economies a bit more. I guess catch‑up by the emerging economies seems to be increasingly the norm, you know, I'm thinking of China, Brazil, India and several others. Do you see the future as being bright for these countries and relatively grim for the so‑called "advanced" economies?

Michael Spence:  No, I don't think so. I mean, we've got lots of problems to sort out in the advanced countries. No, what's going to happen in these countries is that their prospects are bright, but the growth will be relatively high, it will slow down eventually, as they approach, you know, higher income levels because it has to. I mean, we don't grow at those speeds basically because we can't innovate enough to cause it to happen, even in innovative environments like Europe and America and Japan. So, they'll slow down, but they'll be higher income, so they'll be happier and I think we'll be fine, too, provided we don't kind of trip up on a few fundamentals.

I mean, getting the fiscal thing sorted out in America is important. In Europe, I think getting the same thing in a multi‑country context sorted out is pretty important. I think in Europe, for example, we're going to have more bouts of contagion. I mean, it's looking OK now, but it isn't yet a system that's designed properly to maintain stability. I think there has to be more fiscal centralization.

Viv Davies:  You think the sovereign debt crisis is bringing up a whole set of new challenges for Europe relative or compared to the U.S.?

Michael Spence: There's lots of things to worry about in the U.S. I mean our long‑term budget situation doesn't look good because of Medicare and Social Security, but the biggest one, by far, is Medicare. So we have to get that under control. And our state and local governments have budget problems that we have to struggle through that are not going to help with growth, or the recovery, or employment.

And in Europe, I think, there’s a very hard set of problems. You've got a common currency in the Eurozone. You've got some countries that are doing well. You've got other countries that have fiscal problems and probably competitive problems, although I don't know the exact dimensions of them. And they can mute growth, and cause employment, and other problems and instability, risk, and high interest rates because of risk.

The other mega‑trend that's going on in the global economy was identified in a McKinsey Global Institute study, which is, for most of the postwar period, we started out with quite high levels of investment, dominated by the advanced countries because of the war recovery. And there were just a lot of things to invest in.

And that steadily declined over time, and that caused global investment to decline as a fraction of global GDP. We're talking about from maybe 26% to 27% down to 20% to 21%. But 6% of global GDP is a fair amount of money.

And in the mean time, the developing countries were learning how to grow and their investment levels were going up, but they were small enough that they didn't matter. This is sort of a parable that has multiple versions, and we're at this crossover point now. So the investment levels in the developing economies are still high, maybe even rising but high, but they're big. So this thing is doing this.

And so, the McKinsey Institute prediction is that by 2030, the global investment rate, when you look at all the infrastructure that the developing countries have to build, the cities and everything, will be back up to 26 or 27%.

And then, the question mark is the savings rate. But it looks like an environment in which the cost of capital is going to go up. So the lesson I drew from that is let's get our fiscal houses in order before that happens to us, because we're going to be in trouble.

Viv Davies:  What about the Middle East and the rising price of oil? Does this pose a real serious threat to global economic recovery and growth more generally?

Michael Spence:  Well it does in different dimensions. Ben Bernanke said, by itself, it shouldn't derail American growth. I think that's probably right for two reasons. One, energy is not trivial, but it's not a huge fraction of the GDP. And secondly, the short‑run effect is big, but the longer run effect, when the elasticity set in, because people make different decisions and react, are fairly large. So the short‑run elasticity is extremely small, and the effect is just to knock out consumption in another area. And the longer‑run effect is much more muted because people buy different cars, insulate their houses, use public transportation, I mean, all kinds of things. And we've had that experience before, so we know that happens, so I think that part's right.

Countries are different in their dependence on oil. So the effect on the economy should be the same, but the effect on taxes and stuff is very different. So Europe is pretty vulnerable. America is moderately vulnerable. The story in the developing countries is different, and it could derail their growth.

And it hits two ways, three actually. One is it's a bigger fraction of GDP for anybody that's a net importer. Second, it causes inflation problems that are much worse than ours. And third, it feeds through things like food prices and what not, because food is a fairly energy‑intensive set of industries, for the most part. And so, the combination of those things, and very high food and commodity prices, but even just oil, can cause at least headaches in the developing countries, and it could slow their growth down.

Viv Davies:  Michael Spence, thanks very much for taking the time to talk to us today.

Michael Spence:  Well, I thank you. I enjoyed it thoroughly.