The scariest thing about the world economy

Last Updated: Fri, Aug 12, 2011 11:37 hrs

We are definitely in uncharted territory now.

The global economy is looking more fragile and vulnerable than it has at any time since the collapse of Lehmann Brothers nearly three years ago.

In fact, the concerns about its future trajectory should be even greater than they were at that time if the underlying and persistent problems are taken account of.

Two big issues have dominated headlines in recent times: sovereign debt problems in the two biggest economic groupings, the United States and the European Union.

To a dispassionate observer, it can be a source of wonder that what began as a crisis generated by the irresponsible excesses of financial markets has ended up as a problem of debt sustainability for the very governments that were forced to step in and clear up the mess.

But this is an old story, for in history almost every financial crisis has been followed by a crisis of public debt: because the crisis itself causes governments to spend more in bailouts as well as in reviving the economy during the subsequent recession.

The difference is that this time the outcry against public "profligacy" and the attacks by bond markets against what are pronounced to be "unsustainable" levels of government debt have begun well before the global economy is out of the woods.

As a result, everywhere the clarion cry is for fiscal austerity and reductions in government expenditure.

This is so even though employment has not really recovered from the Great Recession in most major economies.

The unemployment rates there are historically high and citizens are already feeling the pinch in terms of reduced public services and higher user charges.

Most striking of all, the strategy of cutting public expenditure will inevitably have a depressing effect on aggregate demand and therefore lower the chances of a real recovery, especially of employment and the indicators that matter to most people.

So what exactly is going on?

In effect, the current problems that the world economy faces are a reflection of the broader inability to contain the political power of finance.

In the US, the dilemma resulted from an almost farcical and essentially political conflict about whether the formal debt ceiling on the US government debt can be raised.

This limit on the debt ceiling is itself the result of a rather odd piece of legislation that was passed in 1939 and then in 1941 as The Public Debt Act, in which the US Treasury was allowed to issue debt to fund federal government operations, but only within a stated ceiling.

Since this ceiling was defined in monetary terms (rather than, for example, as a ratio of GDP), it has constantly had to be increased over the past seventy years.

Since the late 1970s, the US Congress has more or less automatically raised the ceiling when passing the budget. The most recent such increase was in February 2010, when the limit was raised to $14.3 trillion.

But this time around, the Republicans in Congress, pushed by Tea Party activists who wanted to reduce government at all costs, dug in their heels and demanded severe budget cuts including on social security and similar spending.

They also refused to undo any of the massive tax cuts on the rich that were provided by the Bush administration, which could have operated to reduce the deficit.

This intransigence, and the inability therefore of the two sides to come to agreement, created an unprecedented situation, in which the US government faced the prospect of a default on some of its debt if the debt ceiling were not raised!

Even if this game of brinkmanship came to a satisfactory end for now, the underlying message is that one way or another the US government is going to be forced to cut down on its spending.

With the evidence of the weakness of the economic recovery becoming ever more apparent in the low job generation and high unemployment figures, this in turn means that the US economy will be looking towards external demand to enable its recovery.

On the other side of the Atlantic Ocean, things are even worse.

A major financial crisis in Europe has been temporarily staved off by an emergency summit of eurozone leaders, in which Germany and other creditor countries agreed to let the European Central Bank provide a new Euro 109 billion rescue deal for Greece that would allow for extending the maturities of all government debt due to be repaid before 2020.

Most significantly, the banks have been forced to take some haircut in the form of a 20 per cent write down of the value of their outstanding debts.

This is a step in the right direction, especially as the bond market contagion had already hit not just Portugal and Ireland once again, but also touched on the far bigger economies of Italy and Spain, creating fears of an unresolvable meltdown. But it is being argued that this is still too little, too late.

As a fund manager has noted, "this programme is less sticking plaster and more of a proper bandage, but that still doesn't deal with the underlying issues."

The debt write-off is relatively small and officially "voluntary", covering about 80 per cent of Greece's creditors - but it is estimated that around three times that amount will eventually have to be written off if the Greek economy is to achieve a viable public debt to GDP ratio. But in any case, this bailout is being provided with the most stringent conditions requiring further fiscal austerity, which are bound to adversely growth prospects in Greece.

So all the deficit countries in the eurozone are being forced to engage in deep and wide ranging cuts that will reduce economic activity - even as other European economies like the UK and surplus countries like Germany also announce measures to cut public spending!

This is an extraordinarily stupid macroeconomic policy.

Even recent empirical research from the IMF has found that fiscal consolidation has contractionary effects on domestic demand and therefore on GDP. One per cent of GDP cut in the fiscal deficit was found to typically reduce GDP by about 0.5 per cent within two years and raised the unemployment rate by about 0.3 percentage points.

This crazy strategy is driven by the misplaced but unfortunately common belief in each country that it can somehow export its way out of trouble.

The general presumption is that external markets will provide the dynamism required to generate growth in these economies. But obviously, all countries or regions of the world cannot rely on net exports to make their own economies grow, especially if they are intent on suppressing domestic wages and demand to make their own economy more "competitive".

Even China, currently seen as the economic powerhouse of the world, has seen some decline in demand growth in the past two quarters, and in any case its economy is simply not large enough to balance the impact of compression in the US and Europe.

So where is demand for stable global economic expansion to come from? The scary thing is that at present, no one who matters really seems to know.

Earlier columns:

Is Europe rushing headlong into economic destruction?

The Finance Minister has failed the common man

Two burning issues India's Finance Minister must tackle

Renowned economist Jayati Ghosh is the Professor of Economics at the Jawaharlal Nehru University in New Delhi. She is also a member of the National Knowledge Commission set up by the Indian Prime Minister.

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