The popular belief that the sharp global economic downturn since September was not as bad as that in the early years of the Great Depression of the 1930s now seems to be overly optimistic. In fact, the world has been dangerously close to the edge of an economic abyss.
This fact may also help us get more clarity on the current hopes that economic activity is recovering in many parts of the world.
Economists Barry Eichengreen of the University of California at Berkeley and Kevin H. O’Rourke of Trinity College in Dublin say in a recent research paper that world economic activity is plunging “in a Depression-like manner”. The starting point of this startling conclusion is the fact that most recent comparisons between the two great crises are based on American data, even though both were global phenomena.
Eichengreen and O’Rourke compare what happened after June 1929 and April 2008 on three parameters—global industrial output, global stock markets and value of global trade. The two economists report that the drop in these three parameters is worse than it was in the early months of the Great Depression. “… Globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimize this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event.
That leaves us with two questions. One, will the world end up in the sort of painful mess that it found itself in the 1930s? Two, are the current hopes of a quick recovery valid?
Most economists agree that the reason the early shocks in 1929 and 1930 led to a deep depression was a series of policy errors. Central banks let interest rates rise despite the collapse of global demand, partly because of ideological beliefs and partly because of the rigidities of the gold standard. Governments were not at all keen to prop up demand through deficit financing; even US deficits in the FDR era were modest by current standards. And the worst mistake was that country after country embraced protectionism and beggar-thy-neighbour policies.
Policymakers around the world have tried their best to avoid repeating the same disastrous mistakes—they have slashed interest rates, increased money supply, run up deficits and avoided perverse protectionism. The record has not been perfect, but there have been no obvious retreats into the policy mistakes of the 1930s.
That is perhaps one reason why the global economy seems to be stabilizing. US President Barack Obama sees some “glimmers of hope”. US Federal Reserve chairman Ben Bernanke says that there is evidence of the first “green shoots” of an economic recovery, to which economist Willem Buiter responded with a typically acerbic comment that these green shoots are “weeds growing through the rubble in the ruins of the global economy”.
Chinese Premier Wen Jiabao says his government’s fiscal stimulus is working and that the Chinese economy is doing “better than expected”. And Indian Prime Minister Manmohan Singh predicts the world economy will partially recover by September 2009 and that India will then be able to go back to an 8-9% growth trajectory. Each of these leaders has also struck notes of warning that the troubles are not over yet, but there are optimistic undercurrents in their statements.
Fear is receding in the financial markets as well. The rally in equities is well known. Two other measures of fear are showing positive trends: the implied volatility of equity indices and currencies has dropped, even though they are nowhere close to the rock-bottom levels they had reached at the height of the global financial bubble, when investors were demanding very low payments for taking on risks.
So, does all this mean that all is now well in the world economy? That seems unlikely. All that has happened right now is that the steep declines in several macroeconomic parameters and equity values have been stopped. And that takes us back to the disturbing comparison between the 1930s and now by Eichengreen and O’Rourke. World industrial output, value of trade and equity prices have plummeted at a rate that makes any stability seem like a recovery.
This very stability is welcome. But there is a lot of hard work still to be done, especially in America and China. The former has to save more and the latter has to spend more if global imbalances have to be ironed out. The floods of liquidity released to calm financial markets could bring inflation in the wake of even the most tentative recovery in demand. The Western financial sector is still in a mess. A crisis in East Europe could lead to a fresh round of panic and risk aversion.
The probability of another Great Depression is thankfully dwindling; but the Great Recession is still very much here.
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