Column : Fork in the road

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Column : We always overcome

: latest form of financial crisis.

The first scenario has pain, but growth declines by only 2-3% for a couple of years. An alternative scenario is much bleaker.  Think of this as the victory of economic and political systems over ideas.  

There are three factors that could lead to a global slump. First, monetary and fiscal policy could be ineffective.  Monetary policy lacks traction, with limited passthrough from policy interest rates to borrowing rates, and only marginal effects of the inventive quantitative easing by central banks.  Fiscal stimuli are too slow or insufficient to offset private investment and consumption declines.  And fiscal stimulus without growth recovery means future fiscal problems.  Japan has a massive public debt burden after the years of fiscal push of the 1990s. 

Second, deleveraging occurs in a sharp and disorderly fashion, severely disrupting economic activity, with further tightening of the credit crunch on firms and households.

Third, hopes of “decoupling” prove off the mark.  Developing countries are hit hard by multiple mechanisms that are sharper and more prolonged than in the first scenario.  There is heightened risk aversion from international finance, the global credit squeeze stays with us, commodity price declines hit commodity exporters, and there are big falls in export markets for manufactures and traded services. 

India would not be spared.  Investment rates in the 30s can also fall a long way, via the combined effect of the domestic credit squeeze and reduced business confidence.  Consumption-smoothing by households would be limited, and government spending increases restricted by debt constraints and weak capacity. This scenario has high human costs in rich and poor countries alike.  Unemployment would rise steeply. Gains in poverty reduction of in India would be threatened.  Fiscal problems would hurt existing public services. 

Political effects of such a scenario could be nasty.  After years of median wage stagnation in the United States, the combination of big rises of unemployment and disgust at large bailouts for the rich could lead to heightened demands for protectionism, an excess regulatory response and entrenchment of special interests, from farmers to car producers.  Throughout the developing world, old distributional tensions could combine with new narratives on the failure of capitalism to support a lurch toward populism. 

Which of these scenarios is most likely? We don’t know.  There is genuine uncertainty over the parameters in the pathways we understand. And we can be surprised again by new pathways.  The year promises to be very interesting.