Is world economy nearing another Lehman moment?

Is world economy nearing another Lehman moment?

Mumbai: Is the world economy stumbling towards another Lehman moment?

The spectacular collapse of the Wall Street investment bank in September 2008 had led to the deepest economic contraction since the 1930s. The US and European economies were pulled back from the brink after central banks flooded them with free money, tax revenues were used to bail out financial institutions and governments supported aggregate demand by stepping up public spending.

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The bill has now been presented. The massive increases in their budget deficits and public debt have brought the Western economies to the brink of a fiscal crisis. The value of the stock of outstanding government debt in most developed economies is now close to or more than the value of their annual output, compared with the widely accepted prudent limit: a debt-gross domestic product (GDP) ratio of 60%.

Matters came to a head on Thursday, as the US led a brutal global sell-off in equities—the worst since the end of the Western financial crisis and worse than the one we saw after Lehman crumbled to dust.

Friday offered temporary relief as the US reported unexpectedly robust job creation numbers.

On Saturday, credit rating agency Standard and Poor’s downgraded the US to AA+, the first downgrade for the nation since 1941, primarily because US public debt is now $14.3 trillion and set to increase.

The global equity markets, US bond markets and the dollar index will provide clues, when investors come back to their trading screens on Monday, about how they have responded to these events.

Most economists do not expect a sudden collapse in the style of Lehman—which is anyway a rare and unpredictable outlier event—but the risks of a double-dip recession in the West have risen in the past two weeks. Growth is already slowing in these countries, and austerity budgets ensure that governments can no longer spend their way out of trouble.

For example, the US economy grew by a disappointing 1.3% in the second quarter of 2011 even as US President Barack Obama has agreed to cuts in the budget deficit as part of the last-minute deal with the Republicans to raise the federal debt limit. Some $900 billion of spending cutswill kick in from October, part of an agreement to cut the deficit by $2.1 trillion over the next decade. These spending cuts will likely hurt US economic growth further.

The US economy is softening even as Europe continues to struggle with its sovereign debt crisis and Asian manufacturing growth is cooling off because of tighter monetary policies by regional central banks that are fighting high inflation.

These global storm clouds have appeared on the horizon at a time when the Indian economy is already slowing, with most growth forecasts already cut by around 50 basis points compared with the expectations at the beginning of this fiscal year.

One basis point is one-hundredth of a percentage point.

The Reserve Bank of India (RBI) has hinted in its July policy statement—when it took the markets by surprise by increasing its short-term lending rate by a stiff 50 basis points—that it would like to see more demand destruction before it reduces its vigil in the fight against inflation.

Right now, high interest rates have cut demand in only select industries such as automobiles and construction. There could be more pain ahead.

Inflation continues to be stubbornly high, at over 8% for more than 18 months going by the Wholesale Price Index. High inflation expectations are getting embedded in the Indian economy, and have been hovering above the official consumer price indices for many months now.

In his latest policy statement, RBI governor D. Subbarao raised concerns about a “wage-price spiral" engulfing the Indian economy.

However, a global economic downturn, and especially a slowdown in China, would pull down the prices of commodities such as oil and metals. Such deflation will likely take some inflation pressure off the Indian economy.

The roots of the spike in Indian inflation can also be traced back to stimulus put in place after the global shocks hit India in late 2008 and early 2009.

The increase in the fiscal deficit was led by revenue spending rather than capital spending; in other words, it was biased towards consumption rather than asset creation. The revenue deficit had climbed to 5.2% of GDP in FY10.

Inflation shot up when the rise in demand was not met with a comparable rise in production capacity, especially since the capex cycle in the private sector also did not recover.

At 3.4% of GDP, the revenue deficit is still intolerably high and one major reason why the national savings and investment rates are around 2-3 percentage points below their pre-crisis peaks, which shaves off around 0.75-1 percentage point from potential GDP growth, as the Prime Minister’s economic advisory council warned in its new report released on 1 August.

When the Western financial crisis first broke out four years ago, in August 2007 when money markets froze, many commentators had optimistically believed that emerging markets such as India would decouple from the rest of the world and continue to power ahead. What happened subsequently punctured that balloon of hope.

India may continue to be one of the more resilient economies in the world, but it is safe to assume that the evolving crisis in the Western economies will not leave it untouched.

Ashwin Ramarathinam contributed to this story.