Columns - The Sunday Times Economic Analysis

The global recession: Causes, consequences and cure

By the Economist

The world is confused about the global economy. Never in recent times have economists been puzzled so much as about the causes of the global recession and what should be done. At first it was attributed to the sub-prime property market and the excessive ending for real estate. Lack of prudential regulations and supervision of financial institutions and the greed of these institutions to make money were the reasons attributed for the crisis. What began as a problem in the United States soon spread to Western Europe and recessionary conditions spread around the world. No country (except of course the well managed Sri Lankan economy!) appears safe from the consequences of the recession.

Then came the bail outs of big corporations that were in serious problems, most notably the three big giant North American car manufacturers, General Motors, Chrysler and Ford. Soon there was a clamour for more bail outs. Toyota is showing losses that are unheard of. German car manufacturers are being considered for an infusion of funds. For the first time in several decades Japan is expected to have a trade deficit. China is revising its growth estimates and so is India. Retail markets in developed countries are shrinking and export markets of developing countries are in serious danger. The crisis is being described as the worst since the depression of the thirties, others call it worse than the Depression.
Nothing is certain about the crisis. The causes and the consequences are global and their spread and depth is unsure. What we are witnessing is the tip of the iceberg. How long it will last remains unpredictable. The world is groping for a solution quite uncertain of what it should be. In this predicament economists and policy makers have turned to the unfashionable theory of John Maynard Keynes. The prognosis is that there is a lack of effective demand and that demand must be propped up by pump priming. Keynes had put this case at the time of the Depression. He even asked people to be paid for digging holes and then paid for covering them. Are the bail outs a similar exercise?

The problem about turning to Keynes for the solution is that the causes for the current global meltdown may well be different to that of the Great Depression and Keynes solution was basically in a closed economy. Today globalisation, near money and financial instruments, expensive war expenditure, huge trade deficits and trade surpluses have all added to a complexity that may well make the Keynesian solution inappropriate. Bail outs may be propping up manufactures that are not competitive in world markets. People and governments may have been spending more than they had but could get hold of. The solution of pump priming may well exacerbate the problem rather than resolve it.

Paul Krugman is an economist advocating a Keynesian approach. He says: “What the world needs right now is a rescue operation. The global credit system is in a state of paralysis, and a global slump is building momentum ….. Reform of the weaknesses that made this crisis possible is essential, but it can wait a little while. First, we need to deal with the clear and present danger. To do this, policymakers around the world need to do two things: get credit flowing again and prop up spending.”

His analysis is that, “What lies behind the credit squeeze is the combination of reduced trust in and decimated capital at financial institutions. People and institutions, including the financial institutions, don't want to deal with anyone unless they have substantial capital to back up their promises, yet the crisis has depleted capital across the board.” At least this is the prognosis of the immediate problem. Longer term structural problems he feels could wait. Therefore to quote him again, “The obvious solution is to put in more capital. In fact, that's a standard response in financial crises. In 1933 the Roosevelt administration used the Reconstruction Finance Corporation to recapitalize banks by buying preferred stock—stock that had priority over common stock in terms of its claims on profits. When Sweden experienced a financial crisis in the early 1990s, the government stepped in and provided the banks with additional capital equal to 4 percent of the country's GDP—the equivalent of about $600 billion for the United States today—in return for a partial ownership. When Japan moved to rescue its banks in 1998, it purchased more than $500 billion in preferred stock, the equivalent relative to GDP of around a $2 trillion capital injection in the United States. In each case, the provision of capital helped restore the ability of banks to lend, and unfroze the credit markets.”

Krugman’s analysis is far more complex than what we have depicted here for he blames the lack of prudential supervision of financial institutions and the muddle they have made. Therefore there is the need for reform of the financial system. The US has to reform the regulatory, supervisory and prudential framework under which the financial problems arose, He also points out that it is a global crisis requiring global action and the International Monetary Fund has an important role to play in protecting developing countries. An important point he makes is that there are a lack of ideas on how to solve the problem, as was the case with the Great Depression till Keynes came up with a new paradigm.

In a recent article in the New York Times Thomas L. Friedman, (the author of The World is Flat, not to be confused with the late Milton Friedman), pointed the finger in a different direction when he wrote. “We’ve indulged ourselves far too long with tax cuts that we can’t afford, bail outs of auto companies that have become giant wealth-destruction machines, energy prices that do not encourage investment in 21st-century renewable power systems or efficient cars, public schools with no national standards to prevent illiterates from graduating and immigration policies that have our colleges educating the world’s best scientists and engineers and then, when these foreigners graduate, instead of stapling green cards to their diplomas, we order them to go home and start companies to compete against ours.”

Friedman’s analysis was of fundamental weaknesses in the US economy. He adds, “To top it off, we’ve fallen into a trend of diverting and rewarding the best of our collective I.Q. to people doing financial engineering rather than real engineering. These rocket scientists and engineers were designing complex financial instruments to make money out of money — rather than designing cars, phones, computers, teaching tools, Internet programmes and medical equipment that could improve the lives and productivity of millions.”

“For all these reasons,” he argues “our present crisis is not just a financial meltdown crying out for a cash injection. We are in much deeper trouble. In fact, we as a country have become General Motors — as a result of our national drift. Look in the mirror: G.M. is us. That’s why we don’t just need a bail out. We need a reboot. We need a build out. We need a buildup. We need a national makeover.” And he stresses that “we must make certain that every bail out dollar, which we’re borrowing from our kids’ future, is spent wisely.”

The views on the crisis, its consequences and cures remain confusing. The world awaits a new paradigm. Until then there would be some further economic blundering. Today, as was the case during the Depression, there was a lack of ideas on the problem at hand. And John Maynard Keynes at the start of the Great Depression said "We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand."

In as far as the Sri Lankan economy is concerned we have to take countervailing policy measures to cope, as best as we could, the fall out of this global recession. That is indeed a difficult task.

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