The world economy is at a back to the future moment, akin to the story of the 1985 science fiction film where a young boy is accidentally sent back in time to 1955. He is forced to correct certain accidents in the past and then come back to the present.
Leaders of the Group of Twenty (G-20) nations are due to meet in Washington, DC this Saturday to discuss the financial crisis and what can be done about it. There are three big issues they are likely to talk about during the summit. Curiously, all three have come into public gaze and then ebbed away over these past 10 years or so. So, it is time to visit the past before moving into the future.
That these issues have been resurrected shows that the problems have been identified much before the financial crisis hit the world with the force of a tidal wave; it is just that the economic boom in the middle years of this decade lulled policymakers into believing that the problems would go away if they looked the other way.
First, there is the uphill task of designing new rules for the global financial system. The issue first came up after the financial crises in Asia, Latin America and Russia during 1997 and 1998. The symptoms then were the same as what we see now: financial panic, dependence on short-term debt, large bailouts, moral hazard and much else. There was quite a bit of discussions over the next couple of years about how the global financial system could be redesigned—the institutions, rules, incentives and safety valves needed to prevent a repeat of 1997.
There will be a lot of talk in Washington this weekend on similar issues. The meeting has quite grandly been called the first step towards a new Bretton Woods, harking back to a similar attempt in 1944 when delegates from 44 allied countries met in the US town of Bretton Woods for the United Nations Monetary and Financial Conference. The system that emerged two years later served the world economy well till 1973. The chance to establish a modern substitute was missed after 1997. It remains to be seen whether there will be more success this time around.
The second old-new issue that may be discussed this weekend is how to rebalance the world economy. Economists had noted the dichotomy at least six years ago—and warned that it is a threat to global economic stability. In short, the US spends too much and saves too little while China spends too little and saves too much. This fault line was papered over by capital flows. China ran up a huge trade surplus with the US—thanks to an undervalued exchange rate—then sent the dollars thus earned back into the US, which kept interest rates there low and allowed American consumers to borrow further to buy from China.
This arrangement is fragile. China will have to let its currency appreciate and also spend more to prop up the world economy at a time when US demand is weak. The recent announcement that the government in Beijing will spend a jaw-dropping $586 billion over the next two years to support the Chinese economy is a step in this direction because the resultant budget deficit will eat into China’s savings rate.
And now the third issue that could be discussed by world leaders: prices. The world’s major central banks have poured billions of dollars into their economies in an attempt to thaw the credit markets. Will this lead to high inflation later? Or is the world actually headed for deflation because of recession? It is hard to tell. European Central Bank head Jean-Claude Trichet said this week that the rescue missions will have both inflationary and deflationary consequences, depending on the specific country.
Once again, there are echoes from the recent past. The International Monetary Fund had warned in 2003 that the world economy was headed towards deflation, or a generalized fall in prices of goods, services and assets. That was not to be. Just as in recent months central banks led by the US Federal Reserve aggressively cut interest rates and were partly responsible for blowing bubbles in the housing and credit markets. The excess money sloshing in the world economy also sparked off inflation in consumer prices during 2006 and 2007.
The financial crisis may have come like a bolt from the blue, but some underlying issues have been debated in recent years till the economic boom and the global asset bubble dulled scepticism. The crisis is an opportunity to revisit these old themes. Rahm Emanuel, Barack Obama’s new chief of staff, has already said, quite correctly as well, that “you don’t ever want a crisis to go to waste”.
Some good things happen in bad times. The financial summit of G-20 leaders this weekend will be worth watching. There will be no sudden miracles. But let us hope that issues such as new rules for the financial game, a more balanced world economy and the effect of loose money on prices are taken seriously.
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