The Persistent Global Crisis*
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.
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.
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.
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