Many years ago, the economist Charles Kindleberger had identified the pattern of a financial crisis in his classic work, Manias, Panics and Crashes. The crisis is the last phase of a cycle which begins with an initial boom. The upswing usually starts with some change, such as new markets, new technologies or political transformations. It proceeds via credit expansion, rising prices - especially of financial assets - and euphoria. Speculative mania emerge, "as a larger and larger group of people seeks to become rich without a real understanding of the processes involved". Eventually, of course, the markets cease rising and, as a consequence, those who have taken on excessive borrowing find themselves in distress. This generates other failures, and the downslide begins. The final phase can become a self-feeding panic, involving a downward free fall.
 
But then financial markets are notoriously prone to cycles; asset markets have always tended to go boom and bust. This in itself does not necessarily make for major real economic depression unless there are other deflationary forces operating, or unless the effects of the financial failures on the real economy are not counterbalanced by increased spending in some other way. Major economic depressions do not result from credit cycles in themselves, but from a complex interplay of real and financial factors that reinforce each other.
 
The central message of Keynes, many decades ago, was that such a downward spiral can be broken by public action. But as Kindleberger pointed out, in a global economy, such public action depends upon institutions, power configurations and division of national responsibilities which cannot be taken for granted to exist.
 
Thus, deflation can be transmitted across countries, through trade flows through the movements of private capital. In the interwar period which gave rise to the Great Depression, the fears of capital flight and inflation prevented governments from engaging in expansionary fiscal and monetary strategies which could have warded off the crisis. This could happen because in that period there was no clear leader in the capitalist world, ready to take on both the power and responsibilities associated with leadership.
 
Such a leader has to operate at both financial and real levels to prevent economic collapse. It has to avoid widespread financial collapse by continuing to provide funds when others are unwilling, and it must also operate on the real economy, to ensure a continued expansion of demand and economic activity. This means running large trade deficits, and ensuring continued and expanding markets for the exports of countries facing economic difficulties. These duties are in fact necessary for stable international capitalism.
 
But the world economy today has no such leader, despite the clear hegemony of the United States in both political and economic terms. This makes the current deflationary pressures - in terms of both financial and real economic variables - stronger today than they have been at any time since the Great Depression. A snapshot view of the world economy today reveals a picture of stagnation and decline that would have been simply unbelievable even two years ago.

 
The talk of possible recession has been in the air internationally for some time now. And of course, after the September 11 attacks on New York and Washington, the US Government, the IMF and others were quick to seize on this as the excuse for predicting a future downturn, which could then be claimed as the adverse fallout of international terrorism. The truth is of course, that the weakness in the international economy was already well advanced for some time before September 2001. In fact, much of the world economy had actually been experiencing a slowdown or recession for several years before the last quarter of 2001.
 
In fact, the most striking feature of international economic trends during the 1990s was that the US experienced strong growth while most of the other economies in the world system languished. This was essentially because confidence in the US dollar had made American capital markets a haven for the financial investors. This fed a consumption-led boom within the US, and also caused growing current balance of payments deficits for the US economy. The current account deficit of the US reached the record level of $ 450 billion by the end of 2001.
 

These trends made the latter half of the 1990s unique in the history of post-war capitalism or another reason. In the past the country holding the international reserve currency did not face any national budget constraint because it could print money and spend it across the world, since everyone was willing to accept and hold such money. As a result, the government of that country routinely resorted to deficit spending to keep the world economy moving. That is, the US economy played the role of locomotive of world growth by sustaining deficit-financed spending.
 

According to one estimate (published by Morgan Stanley) the growth in US gross domestic product was responsible for about 40 percent of the cumulative increase in world GDP in the five years ending in mid-2000, which is twice America’s share of the global economy. In this period, demand growth in the US was 4.9 per cent per annum compared to 1.8 per cent in the rest of the world. In other words, US economic expansion pulled the rest of the world behind it, at least to some extent.
 

That process ended some time in late 2000. And with the US engine of growth slowing down, it meant that other countries - which had been relying on the huge demand for their exports from the US to keep their own growth rates positive - were adversely affected. This has been immediately evident in terms of world trade. WTO figures suggest that the growth of world trade in volume terms, which was more than 12 per cent in 2000, was only around 2 per cent in 2001. And when this is combined with continued deflation in terms of trading prices in world markets for primary commodities and many manufactured goods, world trade in value terms was stagnant.
 

Patterns of output growth and prices in the major economies
The growth patterns in the major developed industrial countries are crucial indicators of the overall pattern of the international economy.  Chart 1 provides the IMF’s latest estimates and projections of growth of real GDP. It should be noted that these estimates, published in December 2001, are already significantly lower than those published by the IMF just three months earlier. While the IMF has attributed the decline to the September terrorist attacks, it could be argued that the earlier estimates were anyway to optimistic, as many had suggested at the time.

    
  

Thus the United States economy, which had led in terms of growth rates of more than 4 per cent per annum until 2000, fell to only 1 per cent growth of real GDP in 2001. In fact, other sources suggest even lower growth figures for the US for the past year.  Industrial output in particular has been falling for more than a year.
 

Further, this period of slowing growth has been accompanied by decelerating and now even declining price levels, raising a real threat of deflation for the first time since the Great Depression. Chart 2 gives the IMF estimates of changes in consumer prices, which suggest that inflation slowed down sharply and there was deflation in Japan. But other sources point to stronger tendencies towards deflation even in the US economy. Figures from the US Labour Department indicate that while wholesale prices rose by 0.1 per cent in January 2002, they had fallen a cumulative 2.6 per cent in the year to January, which was in fact the biggest 12-month drop in half a century. Similarly, the data on industrial capacity, (only 75 per cent in January 2002) have been argued to reflect strong productivity growth, but they also raise concerns about the risk of deflation - a vicious cycle of falling prices, profits, production and employment. Business investment in the US fell by nearly 13 per cent in the last quarter of 2001 compared to the previous year, making it the fourth consecutive quarter of falling investment.

         

The European Union was supposed to be recovering from 2000, but the past year’s growth performance was once again lower, suggesting that the earlier growth impetus, such as it was, was not sufficient to raise the dynamism in the European economy. Both the IMF and the OECD estimates suggest a further deterioration in aggregate growth performance of the European Union in the coming year.
 

The Japanese economy is currently in the weakest position of all the major capitalist economies. Clearly this economy is in the grip of a classic deflation, with low output, falling prices and poor expectations leading to declining levels of investment. The Japanese government’s own forecasts show that the economy will not grow at all in the fiscal year starting in April, with unemployment continuing to rise, to nearly 6 per cent.  In 2001, prices in Japan fell for the third year in a row, which is unprecedented for a major industrial economy since the 1930s. Furthermore, net export performance has also worsened. There was a 38 per cent fall in the Japanese trade surplus for 2001, the largest fall since 1970 and the third successive year of decline.

   

Accompanying all this has been a strange process of convergence of unemployment rates, as evident from Chart 3. While Japan had always been considered a low unemployment economy largely for structural reasons, it was argued that more “flexible” labour market combined with greater economic dynamism made rates of open unemployment much lower in the US than in Western Europe. But Chart 3 shows that over the recent past, while rates of unemployment have been declining in Europe (despite less impressive output growth) they have been rising in both the US and Japan.

         
 

What is the prognosis, given such a combination of forces in the major economies ? Most analysts have been pessimistic about the prospects of an early recovery, despite the Bush administration’s efforts to provide a fiscal stimulus through large tax cuts and increased spending, especially after September 11. The pessimism ranges from perceptions that the size of the fiscal stimulus is simply not enough to provide the kind of stimulus which is required, to the argument that it has been largely oriented towards tax cuts for large corporations and the wealthy along with increased military spending, neither of which have large multiplier effects.
 

Another view is expressed in a report issued in December 2001 by the Levy Economics Institute, written by economists Wynne Godley and Alex Izurieta. This argued that the current recession in the US is different from earlier recessions because of large structural imbalances in the US economy. According to them, “the United States should now be prepared for one of the deepest and most intractable recessions of the post-World War II period, with no natural process of recovery in sight unless a large and complex orientation of policy occurs both here and in the rest of the world. The grounds for reaching this sombre conclusion are that very large structural imbalances, with unique characteristics, have been allowed to develop. These imbalances were always bound to unravel, and it now looks as though the unraveling is well under way.”
 

In Japan, deflation currently poses the greatest threat.  Not only have prices been falling over the past three years, the rate of decline has been accelerating. Falling prices raise the real level of interest, which explains why the very loose monetary policy with historically low nominal interest rates has not implied falling real rates of interest, This is the classic “liquidity trap” situation. High real rates of interest in a depressed real economy increase the debt burden on both the private and public sectors to potentially unsustainable levels. Over the past decade, the ratio of gross public debt to GDP in Japan has increased from 61 percent to 131 percent, which is now the highest level for any OECD country. If debt levels keep rising in this manner, it is possible that this may lead to a collapse in public confidence in such debt, which in turn can even lead to an Argentina-like crisis with soaring interest rates, high inflation and outright default.
 

This means that the attempt to explain the Japanese economic conundrum in terms of a bloated and opaque banking sector completely misses the point, since it is the macroeconomic conditions which are creating the problems in individual banks as well. Certainly it is the case that in an economy that is already burdened with vast post-bubble debt and a heavy burden of non-performing loans held by the banking system, falling prices and consequently rising real interest rates could result in a spiral of mass bankruptcy, financial contraction and deepening recession.
 

So far the rest of the developed world has tried to ignore the magnitude of the Japanese economic quagmire, and certainly has not provided any meaningful assistance. But there can be significant international implications if the problems get worse, which they seem likely to do at present. Japanese capital has financed a large portion of the US international debt. So an implosion on the Tokyo financial markets, leading to the calling in of funds from the rest of the world, would have major consequences for the world economy. At the very least this would certainly prevent a rapid recovery in US financial markets, but it could have even more devastating financial effects.

   

Policy choices : The fiscal stance
One of the more destructive economic consequences of the downfall of Keynesianism in mainstream policy discussion has been the conscious rejection of the fiscal stance as a major means of changing levels of economic activity. One of the more blatant examples of this has been in the case of the European Union, in which the Growth and Stability Pact of the Maastricht Agreement explicitly restricted the ability of member states to use fiscal deficits to reduce levels of excess capacity and unemployment.

  

Nevertheless it is true that the conditions for using fiscal policy in this manner have changed significantly over the past decade, partly because of the cross-border mobility of finance, which can play havoc with domestic attempts to reflate economies, and partly because of certain other processes. In fact, what is remarkable about the period since the mid-1990s in particular, is the very different effects that fiscal policy have had on particular economies, often completely contrary to received wisdom.

   

Consider the evidence presented in Charts 4a to 4d. The first point to not is how the fiscal deficits have been declining quite rapidly as shares of GDP in all the advanced countries taken as a group, to very low levels. In fact, in terms of structural deficit (that is, accounting for the fact that fiscal deficits move with business cycles, increasing in slumps and declining in booms), the fiscal deficit in the major advanced economies was less than 2 per cent of GDP in the latter half of the 1990s and has been less than 1 per cent thereafter.

   

In the United States, the boom was originally led by large increases in government spending combined with tax cuts. In the mid-1990s, however, the US, despite being the country with the international reserve currency, chose to curtail its fiscal deficits initially. And when the US government was confronted with surpluses in the course of the boom triggered by private spending, it chose to hand over some part of those surpluses to the private sector in the form of tax cuts. As Chart 4b shows, since 1999 the US government budget has been in surplus (negative deficit indicates surplus).