Another crisis coming



Source: By Alok Ray: Deccan Herald



The shadow of the Great Recession beginning from around mid-2008 is still not over for many countries. Even after eight long years, the current growth rate is below the trend growth for all the major economies in the developed world, despite zero or even negative interest rates. Some analysts believe that another crisis may occur anytime. At the same time, another group of influential economists is talking of the possibility of a longer-term secular stagnation for countries like USA or the European Union members.


What causes the prevailing gloom? A number of factors in combination are being held responsible. Even economists who generally believe that globalisation of trade and FDI have brought enormous benefits are highly critical of the role of financial globalisation. They are particularly sceptical about the benefits of financial innovation in the form of complex derivative instruments which many investors do not properly understand. Apart from big loans to well connected businessmen with dubious collateral assets, the banks - increasingly in search of commissions and fees - are still pushing loans for the purchase of houses, automobiles and consumer articles, in excess of the repayment capabilities of many borrowers.


Some analysts focus on a more fundamental problem in the form of a 'global savings glut'. Several countries - including China, Japan and Germany in particular - have amassed huge savings in the form of current account surpluses (and foreign exchange reserves) which are far more than the available investment alternatives in the global economy, even at zero interest rates.


Planned saving (a leakage) exceeding planned investment (an injection) exerts a downward pressure on global demand which results in falling output (recession) and/or falling prices (deflation). More countries like China and Germany grow on the basis of massive current account surplus, it becomes so much difficult for other countries with corresponding deficit (like theUS and much of non-German EU) to maintain growth by creating adequate demand.


The tendency of inadequate expenditures is being further accentuated by several factors. One, huge debt overhang (both public and private) from earlier periods is still restraining current expenditures in many developed countries. Two, rising income inequality (redistribution from wages to profits and within wages to a small percentage of people at the top) is reducing aggregate expenditures as the marginal propensity to spend is lower for the richer people.


Third, a premature winding of fiscal stimulus to counter recession (for the fear of unsustainable public debt) and almost exclusive reliance on monetary stimulus going to the extreme of negative interest rates beyond which it cannot go any further. Maintaining a near-zero interest rate for over seven years in countries like USA and even longer in countries like Japan (now having negative policy interest rate) always runs the risk of fuelling a credit bubble in stocks and housing markets. Monetary policy focusing on inflation targeting does not help much to curb this credit bubble as the resulting inflation in housing and stock markets does not get adequately reflected in the wholesale or consumer price index which is the measure of inflation used in inflation targeting.


Further, given the paucity of both public and private expenditure to maintain full employment or the trend growth rate of the past, there is always the macroeconomic need for boosting consumption expenditure by expansion of credit. Therein lies the risk of fuelling another financial crisis starting with excessive bank credit and then a sudden halt to credit flows even to otherwise sound companies and borrowers once the repayment problem from unsound borrowers rears its head. Also, despite a lot of talk on the need for rebalancing in China and Germany from export-led growth to consumption-led growth, no significant progress has been achieved so far. Consequently, the chances of a secular stagnation arising out of the continuing global savings glut are considerable.


State-owned banks


A greater worry than a slowing China is the way China is trying to maintain its credit-fuelled growth by injecting even more credit through the state-owned banks which increases the risk of a harder landing later. The huge excess capacity built in the steel, cement, glass and other construction related sectors in China and its attempt to dump these at low prices in the global markets is making it even more difficult for the competing firms in other countries to sustain their output and profits.


What could be the possible way out? Some suggest a far greater reliance on fiscal stimulus without bothering about the creation of public debt. In fact, given the near-zero real interest rate, this could be the golden opportunity for the governments to borrow and spend on creating and improving the infrastructure in both developed and developing economies.


This would raise the productive capacity and potential growth rate of the future along with creating aggregate demand in the short-run which is the urgent need of the hour. Higher growth may well cut the budget deficit to GDP ratio (and new debt creation) by raising tax revenues, reducing expenditure on unemployment benefits and raising the denominator (GDP).

Is another global recession round the corner? Here, analysts differ. Even the doomsayers are talking of a high probability of a big recession in the next four years or so, though not in the immediate future. But, then, don't forget that historically, on average, a recession has hit the world economy once in five-six years. Therefore, the forecasters may well be right, even if their underlying analysis may not be exactly correct.