Exactly a year back, the authoritative Business Cycle Dating Committee of the US National Bureau of Economic Research declared that the US economy had experienced a trough in business activity in June 2009. That trough, in its view, marked the onset of recovery and the end of an 18-month-long recession that had begun in December 2007.
A year later, as the world's financial leaders gather in Washington D.C. for the annual meetings of the World Bank and the IMF, that assessment appears optimistic.
The OECD Secretariat suggests that the world is possibly returning to a period of recession, and that the recovery sited by the Dating Committee was more a blip than the trend. In its interim assessment of the outlook for OECD countries released on September 8, 2011, it noted that the recovery had almost come to a halt even by the second quarter of 2011 in most OECD countries.
Even though annual quarter-on-quarter growth rates have not returned to the negative territory, they had been in between the third quarter of 2008 and the fourth quarter of 2009, there are four reasons for gloom.
First, when we compare growth in any quarter relative to the same quarter of the previous year, there is evidence of a significant decline in growth rates between the last quarter of 2010 and the second quarter of 2011 (Chart 1).
Second, when we examine the annualised growth in any quarter relative to the immediately preceding quarter, that rate has fallen significantly in all major OECD countries, including in the Euro 3 or the core eurozone countries, namely, Germany France and Italy (Chart 2). Third, there is evidence that this time round emerging market economies are being impacted quite early. According to the interim assessment, growth in China eased in the course of the first half of the year and manufacturing production has weakened.
Finally, the OECDs models projecting growth, using lead indicators, predict that growth in the G7 economies, even excluding accident-ravaged Japan, was likely to be less than 1 per cent (annualised), with significantly higher risk of more negative growth in some major OECD economies.
The damage this slide into a second recession would inflict on populations still reeling under the effects of the Great Recession comes through from the OECD's recently released Employment Outlook . Unemployment rates in all leading economies are not very much below the peak levels they rose to during the recession and are well above the immediate pre-recession lows they had touched. One in every 12 persons in the workforce is unemployed in the OECD group of countries.
The figure is one in every 10 for the EU, and as high as one in every five or seven in Spain or Greece (Chart 3). This does not take account of the many who have stopped seeking work and dropped out of the workforce because of the high levels of long-term unemployment.
‘Stimulus packages'
There are three important reasons why the unemployment problem has persisted and a real economy growth crisis seems imminent. The first is that the stimulus adopted in response to the 2008 crisis was grossly inadequate in most countries and was substantially dissipated in tax cuts and bail-out packages, which left little for spending that would have strong multiplier effects, drive long-term growth and expand employment.
Since governments did not clearly demarcate the sums allocated for these different kinds of expenditures in their “stimulus packages”, the inadequacy of those packages was not fully recognised. Moreover, those packages could not ensure that the recovery would lead to the mobilisation of additional tax revenues that could sustain expenditures. Sustained recovery was dependent on continuous injections of demand and liquidity.
The second is that having borrowed to finance these insufficient and inappropriate expenditures, governments have convinced themselves or been pressured by lenders into believing that they have not just exhausted their fiscal headroom but borrowed too much and need to retrench substantially.
The fear of “excess” public debt and the danger of sovereign default was used not just to halt the hikes in public borrowing resorted to in the immediate aftermath of the 2008 crisis, but to require countries to opt for contraction and austerity.
What was and is being forgotten here are two important facts. The first is that growth driven by stimulus spending helps to deliver increases in tax revenues that can partly finance those expenditures. The second is that governments, unlike households, have the right and the instruments to tax the incomes and wealth of others to raise resources to meet their debt service commitments.
Slowdown in growth
This kind of blind fiscal conservatism led to the withdrawal of stimulus measures and a turn to expenditure reduction. The result was not just slower growth but the forfeiture of the principal remedy for recession since the Great Depression: Enhanced public expenditure. Governments voluntarily gave up their right to resort to fiscal means to reverse the deceleration in growth even in countries that were not recording large fiscal deficits and faced no threat of a public debt crisis. This not only directly affected growth in individual countries. It also meant that countries that were dependent on exports to global markets to sustain much of their dynamism, whether it be Germany in Europe or China in Asia, also experienced a slowdown in growth.
The third reason was the deep flaw in the way the Eurozone had been constituted. Economic borders between differentially developed countries were diluted making the less developed easy targets for exports from the more developed. Yet, the ability of individual countries to opt for devaluation to enhance national competitiveness was undermined by the adoption of a common currency.
This meant that stronger countries like Germany could sustain growth based on exports to the rest of the Eurozone. On the other hand, weaker countries inundated with imports depended on non-tradable activities and government expenditure financed with borrowing for whatever growth they realised.
They could manage because of the easy access to credit ensured by the strength of the common currency. Indeed, the capital inflows associated with this credit operated to push up the real exchange rates (that is the level of domestic prices) of recipient countries compared to the “strong” countries, and this generated further imbalance.
The risks of such a strategy were underestimated because of the belief that the more developed Eurozone partners will pull the less developed ones up the economic ladder. When borrowing reached levels perceived as excessive and the expected growth supported by the more developed was not forthcoming, the ability of these countries to meet their debt service commitments was brought into question. The fear of sovereign default was the result.
Fear of default
That fear may prove self-fulfilling. Countries like Greece, that have indeed borrowed considerably, find that new credit is difficult to come by and what is available is extremely costly.
On the other hand, their partners in the Eurozone are unwilling to provide them the required credit or the guarantees that would help them sustain expenditures and meet their debt service commitments. In the event, countries in crisis and in danger of defaulting on debt are forced to adopt severe austerity measures to persuade creditors to roll over and provide new debt. But such austerity measures not only reduce growth, they squeeze government revenues as well.
Hence, despite and even partly because of the austerity measures, deficit countries find themselves unable to service the debt they are burdened with. The fear of default could prove to be a self-fulfilling prophecy, not despite but because of austerity and slow growth.
That things have come to such a pass is surprising, given the implications of sovereign default. If the Greek government defaults on its debt, for example, the banks in Greece that have lent hugely to their government could face insolvency. If that happens, the problem would not be confined to Greece alone. After all, perceived excess borrowing is a problem facing other governments as well, both within and outside Europe.
A banking meltdown in Greece would, at the least, get both rating agencies and depositors to re-examine their views on the banks they have hitherto taken to be safe. So contagion is a real danger, since a run on individual banks or a ratings downgrade that wipes out the backing offered by available Tier-1 capital can weaken banks elsewhere.
Further, while it is indeed true that much of the government's debt in a country like Greece is owed to Greek banks, a substantial chunk is owed to banks outside Greece as well. This is to be expected, since with a common currency the geographical boundaries between nations are even less relevant to finance than they would be if such boundaries also defined economies with separate currencies and distinct currency risks. So a Greek sovereign default could damage banks outside Greece as well.
This would increase uncertainty, cut off lending and precipitate a financial collapse and a real economy crisis. Not surprisingly, as the Greek problem turned intractable, banks' shares (such as those of Societe Generale and Credit Agricole) took a severe beating. The signal was clear. For more reasons than one, the rest of the Eurozone or even the world outside the Eurozone cannot pretend that the problem at hand is that of a Greece or a Portugal, which must be left to its own devices.
Public debt burden
The problem is more general and the solution requires not just European but global cooperation. That solution must reinvigorate the recovery and help generate the confidence and the revenues required in countries where the public debt burden is onerous.
This requires a coordinated effort at enhancing public spending, sharing the losses of reducing the debt burden with banks also taking a hair cut, and saving banks faced with the danger of insolvency.
Yet fiscal conservatism and the misplaced belief that the problem is that of the others seem to be delaying even the effort at such a resolution. Thus far, the assumption has been that that the stimulus to growth would come from the private sector, and that the resulting output growth will enhance revenues to an extent where governments can resolve their public debt problems.
Not surprisingly, the IMF Managing Director, Ms Christine Lagarde, has expressed disappointment that “in key advanced economies, the necessary hand-off from public to private demand is not taking place”. This ignores the lessons from the run up to the 2008 crisis. The crisis was the culmination of a trajectory of growth in which debt financed private investment and consumption provided the demand-side stimulus for growth.
That trajectory required a huge expansion in the universe of borrowers and the volume of debt. Since leverage of that kind could not be sustained, the financial and economic crises ensued. It is unlikely that the private sector would once again be able to increase its borrowing substantially.
What is needed, therefore, is more emphasis on sustainable ways of raising public demand while adopting policies that share the costs of preventing a banking sector collapse.