Exactly a year back, the authoritative Business Cycle
Dating Committee of the US National Bureau of Economic
Research declared that the US economy had experienced
a trough in business activity in June 2009. That trough,
in its view, marked the onset of recovery and the
end of an 18-month-long recession that had begun in
December 2007.
A year later, as the world's financial leaders gather
in Washington D.C. for the annual meetings of the
World Bank and the IMF, that assessment appears optimistic.
The OECD Secretariat suggests that the world is possibly
returning to a period of recession, and that the recovery
cited by the Dating Committee was more a blip than
the trend. In its interim assessment of the outlook
for OECD countries released on September 8, 2011,
it noted that the recovery had almost come to a halt
even by the second quarter of 2011 in most OECD countries.
Even though annual quarter-on-quarter growth rates
have not returned to the negative territory they had
been in between the third quarter of 2008 and the
fourth quarter of 2009, there are four reasons for
gloom. First, when we compare growth in any quarter
relative to the same quarter of the previous year,
there is evidence of a significant decline in growth
rates between the last quarter of 2010 and the second
quarter of 2011 (Chart 1). Second, when we examine
the annualised growth in any quarter relative to the
immediately preceding quarter, that rate has fallen
significantly in all major OECD countries, including
in the Euro 3 or the core eurozone countries, namely,
Germany France and Italy (Chart 2). Third, there is
evidence that this time round emerging market economies
are being impacted quite early. According to the interim
assessment, growth in China eased in the course of
the first half of the year and manufacturing production
has weakened. Finally, the OECDs models projecting
growth using lead indicators predict that growth in
the G7 economies, even excluding accident-ravaged
Japan, was likely to be less than 1 per cent (annualised),
with significantly higher risk of more negative growth
in some major OECD economies.
The damage this slide into a second recession would
inflict on populations still reeling under the effects
of the Great Recession comes through from the OECD's
recently released Employment Outlook. Unemployment
rates in all leading economies are not very much below
the peak levels they rose to during the recession
and are well above the immediate pre-recession lows
they had touched. One in every 12 persons in the workforce
is unemployed in the OECD group of countries. The
figure is one in every 10 for the EU, and as high
as one in every five or seven in Spain or Greece (Chart
3). This does not take account of the many who have
stopped seeking work and dropped out of the workforce
because of the high levels of long-term unemployment.
Chart
1 >> Click
to Enlarge
There
are three important reasons why the unemployment problem
has persisted and a real economy growth crisis seems
imminent. The first is that the stimulus adopted in
response to the 2008 crisis was grossly inadequate
in most countries and was substantially dissipated
in tax cuts and bail-out packages, which left little
for spending that would have strong multiplier effects,
drive long term growth and expand employment. Since
governments did not clearly demarcate the sums allocated
for these different kinds of expenditures in their
''stimulus packages'', the inadequacy of those packages
was not fully recognised. Moreover, those packages
could not ensure that the recovery would lead to the
mobilisation of additional tax revenues that could
sustain expenditures. Sustained recovery was dependent
on continuous injections of demand and liquidity.
The second is that having borrowed to finance these
insufficient and inappropriate expenditures, governments
have convinced themselves or been pressured by lenders
into believing that they have not just exhausted their
fiscal headroom but borrowed too much and need to
retrench substantially. The fear of ''excess'' public
debt and the danger of sovereign default were used
not just to halt the hikes in public borrowing resorted
to in the immediate aftermath of the 2008 crisis,
but to require countries to opt for contraction and
austerity. What was and is being forgotten here are
two important facts. The first is that growth driven
by stimulus spending helps to deliver increases in
tax revenues that can partly finance those expenditures.
The second is that governments, unlike households,
have the right and the instruments to tax the incomes
and wealth of others to raise resources to meet their
debt service commitments.
Chart
2 >>
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to Enlarge
This kind of blind fiscal conservatism led to the
withdrawal of stimulus measures and a turn to expenditure
reduction. The result was not just slower growth but
the forfeiture of the principal remedy for recession
since the Great Depression: enhanced public expenditure.
Governments voluntarily gave up their right to resort
to fiscal means to reverse the deceleration in growth
even in countries that were not recording large fiscal
deficits and faced no threat of a public debt crisis.
This not only directly affected growth in individual
countries. It also meant that countries that were
dependent on exports to global markets to sustain
much of their dynamism, whether it be Germany in Europe
or China in Asia, also experienced a slow down in
growth.
The third reason was the deep flaw in the way the
Eurozone had been constituted. Economic borders between
differentially developed countries were diluted making
the less developed easy targets for exports from the
more developed. Yet, the ability of individual countries
to opt for devaluation to enhance national competitiveness
was undermined by the adoption of a common currency.
This meant that stronger countries like Germany could
sustain growth based on exports to the rest of the
Eurozone. On the other hand weaker countries inundated
with imports depended on non-tradable activities and
government expenditure financed with borrowing for
whatever growth they realised. They could manage because
of the easy access to credit ensured by the strength
of the common currency. Indeed, the capital inflows
associated with this credit operated to push up the
real exchange rates (that is the level of domestic
prices) of recipient countries compared to the ''strong''
countries, and this generated further imbalance.
The risks of such a strategy were underestimated because
of the belief that the more developed Eurozone partners
will pull the less developed ones up the economic
ladder. When borrowing reached levels perceived as
excessive and the expected growth supported by the
more developed was not forthcoming, the ability of
these countries to meet their debt service commitments
was brought into question. The fear of sovereign default
was the result.
That fear may prove self-fulfilling. Countries like
Greece, which that have indeed borrowed considerably,
find that new credit is difficult to come by and what
is available is extremely costly. On the other hand,
their partners in the Eurozone are unwilling to provide
them the required credit or the guarantees that would
help them sustain expenditures and meet their debt
service commitments. In the event, countries in crisis
and in danger of defaulting on debt are forced to
adopt severe austerity measures to persuade creditors
to roll over and provide new debt. But such austerity
measures not only reduce growth, they squeeze government
revenues as well. Hence, despite and even partly because
of the austerity measures, deficit countries find
themselves unable to service the debt they are burdened
with. The fear of default could prove to be a self-fulfilling
prophecy, not despite but because of austerity and
slow growth.
Chart
3 >>
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to Enlarge
That things have come to such a pass is surprising,
given the implications of sovereign default. If the
Greek government defaults on its debt, for example,
the banks in Greece that have lent hugely to their
government could face insolvency. If that happens,
the problem would not be confined to Greece alone.
After all, perceived excess borrowing is a problem
facing other governments as well, both within and
outside Europe. A banking meltdown in Greece would,
at the least, get both rating agencies and depositors
to re-examine their views on the banks they have hitherto
taken to be safe. So contagion is a real danger, since
a run on individual banks or a ratings downgrade that
wipes out the backing offered by available Tier 1
capital can weaken banks elsewhere.
Further, while it is indeed true that much of the
government's debt in a country like Greece is owed
to Greek banks, a substantial chunk is owed to banks
outside Greece as well. This is to be expected, since
with a common currency the geographical boundaries
between nations are even less relevant to finance
than they would be if such boundaries also defined
economies with separate currencies and distinct currency
risks. So a Greek sovereign default could damage banks
outside Greece as well. This would increase uncertainty,
cut off lending and precipitate a financial collapse
and a real economy crisis. Not surprisingly, as the
Greek problem turned intractable, banks' shares (such
as those of Societe Generale and Credit Agricole)
took a severe beating. The signal was clear. For more
reasons than one, the rest of the Eurozone or even
the world outside the Eurozone cannot pretend that
the problem at hand is that of a Greece or a Portugal,
which must be left to its own devices.
The problem is more general and the solution requires
not just European but global cooperation. That solution
must reinvigorate the recovery and help generate the
confidence and the revenues required in countries
where the public debt burden is onerous. This requires
a coordinated effort at enhancing public spending,
sharing the losses of reducing the debt burden with
banks also taking a hair cut, and saving banks faced
with the danger of insolvency.
Yet fiscal conservatism and the misplaced belief that
the problem is that of the others seem to be delaying
even the effort at such a resolution. Thus far, the
assumption has been that that the stimulus to growth
would come from the private sector, and that the resulting
output growth will enhance revenues to an extent where
governments can resolve their public debt problems.
Not surprisingly, IMF Managing Director Christine
Lagarde has expressed disappointment that ''in key
advanced economies, the necessary hand-off from public
to private demand is not taking place''. This ignores
the lessons from the run up to the 2008 crisis. The
crisis was the culmination of a trajectory of growth
in which debt financed private investment and consumption
provided the demand-side stimulus for growth. That
trajectory required a huge expansion in the universe
of borrowers and the volume of debt. Since leverage
of that kind could not be sustained, the financial
and economic crises ensued. It is unlikely that the
private sector would once again be able to increase
its borrowing substantially. What is needed, therefore,
is more emphasis on sustainable ways of raising public
demand while adopting policies that share the costs
of preventing a banking sector collapse.
*
The article was originally published in the Business
Line, September 20, 2011
