Dealing with the global economic crisis

Everyone is anxious for the good days to return. Every day, economists, policymakers and politicians make predictions about when the economic recovery will start.
Are we all Keynesians now? When Paul Krugman asked the question in his preface to the 2005 edition of Keynes’ General Theory of Employment, Interest and Money, little would he have anticipated that it would hit the headlines around the world so soon.

As the enormity of the biggest economic crisis of the 21st century slowly sank in, nations scrambled to find quick solutions and committed billions of dollars to Keynesian-style public policy stimulus programmes — and sometimes to infamous bailouts of beleaguered financial giants.

President Barack Obama underlined the approach to the U.S. economy, the key to world recovery. On the eve of his inauguration he said, “There is no disagreement that we need action by our government, a recovery plan that will help jump-start the economy.”

However, to suggest that the debate has been settled would be unfair to the robust reasoning of the protagonists of free market incentives — the redoubtable Chicago School and the legatees of Milton Friedman and of the Austrian thinkers Friedrich Hayek and Ludwig von Mises. The Cato Institute published a full-page advertisement in leading newspapers in January. It was a statement signed by more than 200 economists telling Mr. Obama how flawed his thinking was.

The signatories included Nobel laureates Edward Prescott, Vernon Smith and James Buchanan and they did not mince words in telling the President that all economists were not Keynesians. More government spending by Hoover and Roosevelt, they said, did not pull the U.S. economy out of the Great Depression of the 1930s. Any belief that government spending could do the trick was just a “triumph of hope over experience.”

The present crisis has striking similarities with the Great Crash and the Great Depression, but also some fundamental differences. Now the world economy is more globally linked and so is the spread of ill-effects. Therefore, the need for closer cooperation and coordination in the recovery effort is far greater today.

The world waited expectantly for the G20 meeting in April to provide the healing balm. G20 came and went. Billions are now passé; trillion is the new idiom. G20 certainly lived up to this trend and committed a whopping $5 trillion to a booster dose by 2010. It acknowledged the importance of increasing the lending capacity of the international financial institutions. But it also left a nagging feeling that between rounds of cocktails, photo ops and polite and diplomatic country statements, it lacked the time to address some fundamental issues.

Take the need to closely look at the capacity of our international institutions to read early warning symptoms and initiate timely corrective actions. In 1955, John Kenneth Galbraith warned in his delightful book on the Great Crash of 1929 that Wall Street needed a close watch: “Wall Street, in these matters, is like a lovely and accomplished woman who must wear black cotton stockings, heavy woollen underwear, and parade her knowledge as a cook because, unhappily, her supreme accomplishment is as a harlot.”

With the nightmare of the Crash still fresh and the scars of World War II still visible, presidents, prime ministers, economists, diplomats — anyone who mattered in the world of financial policy — gathered at Mount Washington Hotel in lovely Bretton Woods in 1945 to work out systems and institutions that would ensure economic reconstruction and future stability. They hoped that the world would not have to go through that harrowing experience again.

And then 2008 happened, with astounding similarities. Financial overheating and meltdown created a crisis of unprecedented dimensions. And the institutions — the IMF, the ADB and the World Bank — so carefully built and nurtured to protect the world just failed to see the gathering storm. The IMF has been quoted as admitting that “Our warning systems within and outside the Fund were insufficiently specific, detailed or dire to gain traction with the policymakers.”

It is more than a coincidence that financial overheating was not the major problem in India as it was in the West. Different players try to take credit — prudent central banking policy and the presence of solid banking PSUs. It is interesting that many free market economies are seriously debating more control of the financial sector. Bo Lungdren, architect of Sweden’s bank rescue in the 1990s and head of the Swedish National Debt Office, told a congressional hearing that the government should consider bank nationalisation if needed to stem the deepening financial crisis.

It is a curious twist of history that decades after Indira Gandhi’s bank nationalisation created a storm in India, the much criticised idea has found endorsement from capitalist economies under siege.

But the world does not yet have a very precise and authentic understanding of the depth of the crisis. There are tell-tale indications. Forbes’ 2009 list of billionaires tumbled. Figures in billions and trillions have been casually bandied around. An ADB report in March reported a loss of $50 trillion — equal to a year’s global GDP. The International Institute of Finance, Washington, DC, estimated that the U.S. household net worth had fallen from around $62 trillion in 2007 to $47 trillion now. Jeffrey Sachs says the decline in wealth in the U.S., Europe and Asia would be of the order of $25 trillion.

Just before the crucial G 20 meeting, the IMF came out with a grim assessment: for the first time in 60 years the world was experiencing economic contraction. In the last quarter of 2008, global GDP had fallen by an unprecedented five per cent. The economic crisis had “battered global economic activity beyond what was anticipated”.

The report refocussed attention on three key areas. First, the much talked about need for strong international policy response and coordination. Second, the importance of moving away from half-hearted sops to a strong, comprehensive fiscal and monetary stimulus. Globally, the IMF report reminded us, fiscal policy was still falling short of the two per cent of GDP stimulus the IMF thought was needed to tackle the situation. Third, it warned against ignoring the lessons of the past — “the rising spectre of trade and financial protectionism.”

These prescriptions are well known. The G20 pledged to “name and shame” protectionist countries and agreed to “act urgently” to conclude the Doha round. These are pious intentions; the intricacies of world trade regulations always leave enough escape routes for the real culprits.

At the G20 meeting in November 2008, when the dimensions of the crisis were still hazy, it was decided not to impose any restriction for 12 months. Yet a World Bank study has shown that since then 17 members of G20 and other nations have imposed a total of 47 measures that restrict trade. The European Union has provided new export subsidies of the type the world trade talks aimed to eliminate. Subsidies proposed for industry have proliferated, totalling some $48 billion. Ninety per cent of these are in high income countries.

The results are not hard to see. Just before the G20 meeting, Pascal Lamy, Director-General of WTO, pointed out that after continuous growth since 1982, global trade declined by nine per cent in 2008. “Use of protectionism measures is on the rise,” he warned, deepening fears of recession and belying the hope that trade could be used as the engine of recovery.

And yet at the G20 press briefing, Britain’s Prime Minister Gordon Brown used an assessment by Mr. Lamy to downplay the lurking dangers of creeping protectionism. The WTO report, he said, suggested that while there had been some violations of WTO norms by member-countries, these were not substantial.

The world would most sincerely wish it were so, but doubts will linger. In a critical situation of major job losses and social unrest, will President Obama and others have the courage to pursue a liberal trade agenda? The rhetoric of “Bangalore versus Buffalo” and the tax disincentives for American companies that outsource jobs tell their own story. Ironically, Federal Reserve Chairman Ben Bernanke says lack of political will constitutes the “biggest risk” to recovery.

Everyone is anxious for the good days to return. Every day, economists, policymakers and politicians make predictions about when the recovery will start, as if it were a 100m sprinter waiting for the starting signal.

The best of such statements can only be guesswork. In 1929, Galbraith writes, every day the worst seemed to worsen: “What looked one day like the end proved on the next day to have been only the beginning.” Public perception of government assurances was so low that every time officials made an optimistic statement, the market dropped. Things are not that bad as yet but they could be. This is no time for complacency.