In a congregation reminiscent of post-war global economic reconstruction efforts, the Group of 20 (G-20) leaders will meet in London in early April to labour a path out of arguably the greatest economic policy challenge since the war. This article will attempt to review the circumstances that triggered this crisis and explore a few of the challenges that will strain global leaders in the days ahead.
The last two decades have seen an unprecedented build-up of global macroeconomic and structural imbalances, all riding piggyback on a series of bubbles. First, the bubbles in technology shares and real estate in the US generated a widely shared “wealth effect” that triggered off a massive consumption boom. Second, there was a proliferation of over-the-counter derivatives, driven by a surge in securitization of financial assets and amplified by high leverage, which saw the financial sector assume disproportionate importance.
Illustration: Jayachandran / Mint
These bubbles were sustained by a number of striking complementarities between the US and “emerging economies”. Huge surpluses from savings and exports of these economies financed debt and consumption in the US, keeping interest rates at historic lows. Cheap exports from the latter fed the voracious appetites of consumers in the former.
The subprime mortgage bubble was only a subset of this spectacular house of cards built on ether. The larger bubble was the trilogy of international trade in goods and services, cross-border capital flows and unprecedented global economic growth.
The two touchstones of this globalization—cross-border capital flows, and trade in goods and services—are now in retreat, and with some vengeance. The bursting of the subprime bubble saw a stampede of deleveraging and repatriation of capital by Wall Street firms from emerging economies, sending the dollar soaring in a direction contrary to economic wisdom.
The recession has taken a heavy toll on the export-dependent East Asian economies. The slump in global demand has dramatically reduced their exports, leading to negative growth in many of them in the last quarter of 2008. A deep sense of uncertainty and fear has gripped the world economy, forcing credit markets to run dry, consumers to postpone purchases, and businesses to defer investments.
The rapidly falling inflation in both developed and developing economies throws open the doors for what Nouriel Roubini calls a “stag-deflation”—a vicious cycle of recession and deflation. Further, through increased real debt burden, deflation can devastate the debt-laden global economy. The low interest rates across the world, kissing the zero-bound, forecloses conventional monetary policy responses to stimulate growth.
There are signs that the worst may be yet to come. As East European stock markets rose alongside other emerging economies and oil and commodity prices soared, their private firms borrowed heavily in euro and other foreign currencies from West European banks to finance ambitious expansion plans. Now, as such economies slow, as company balance sheets deteriorate and depreciating currencies inflate the real debt burden, many borrowers look likely to default. These economies increasingly are reminiscent of East Asia in the late 1990s, and their debts may be the equivalent of subprime mortgages for the West European banks.
The biggest cause for concern is that every major economy—developed or developing—and every sector—services or manufacturing—is badly affected, thereby leaving the global economy with no engine to pull itself out of trouble. Previous crises were confined to a few sectors or economies, which could then rely on others to bail them out. Accordingly, the East Asian economies and Japan rode on US consumer demand to export their way out of trouble.
Further, as the crisis deepens and job losses mount, it is inevitable that protectionism rears its ugly head. Paul Krugman has argued that fiscal policies exhibit positive externalities, insofar as “my fiscal stimulus helps your economy, by increasing your exports—but you don’t share in my addition to government debt”. Therefore, without global coordination, there would be too little stimulus and demand for protectionist policies to capture benefits locally.
Any long-term solution will have to primarily address the fundamental structural and macroeconomic imbalances. The emerging economies should desist from exchange rate manipulation; develop their financial markets to provide investment opportunities for domestic savings; diversify their forex reserve holdings; and stimulate consumer spending to tap their domestic market potential. Developed economies, especially the US, should learn to live within their means, their households have to save more and spend less, and increase exports to bridge their deficits.
Effective regulation of financial markets, tighter controls on cross-border capital flows, and a strong and sufficiently capitalized multi-lateral institution—to act as an effective and credible global lender of last resort—can well reassure countries to undertake the aforementioned reforms.
That a crisis in a small sliver of Wall Street has wreaked such havoc on even distant economies with strong fundamentals and minimal exposure to those assets is a testament to the interconnectedness of the global financial markets and world economy. It is, therefore, but natural that individual economies have limited luxury to export or stimulate their way out in isolation.
In any case, all indications are for a long, arduous and painful climb up the economic recovery incline, lending weight to Roubini’s claim that recovery could well be L-shaped.
Gulzar Natarajan is a civil servant. These are his personal views. Comments are welcome at email@example.com