Column : Fork in the road

Written by Michael Walton | Michael Walton | Updated: Jan 3 2009, 04:37am hrs
After the global economic turbulence of 2008, what does the future hold This is unusually hard to call. Consider two scenarios.

First lets look at what could happen with a positive spirit. Think of this as the victory of ideas over interests and economic complexitythe true legacy of Keynes. 2008 experienced the most dramatic financial crisis since the Great Depression. Most of the industrialised world is in recession, and commodity and asset prices have collapsed.

But it could have been a lot worse.The financial system was saved from implosion. It seemed interminable at the time, but there was, by historical standards, an impressive response from the US, Europe and many developing countries. This involved strikingly pragmatic government involvement in the financial system, unprecedented monetary easing, and a near-consensus on the desirability of contracyclical fiscal policy.

Good ideas and good policy could keep the recession in rich countries modest and brief, with monetary action acquiring traction, credit flowing, and fiscal expansion working. Smart financial policy would support the smooth deleveraging of the financial system.

The developing world would suffer a slowdown, but this would be modest and temporary. China undertakes a genuine fiscal stimulus and succeeds in increasing domestic consumption, compelled by the political necessity to keep growth rates above 7-8 percent. India suffers from lost export markets and indirect effects of the international credit crunch, but growth rates would only dip to around 5 percent.

There would also be silver linings. A better form of regulated financial capitalism will emerge, bringing the shadow banking system into the fold of core regulatory structures with more effective market and societal scrutiny. Financial innovation would indeed slow down, and financial sector rewards would no longer be at obscene levels, but this will induce the best talents to go back into the real economy. Physicists will do science rather than write models of asset price behaviour.

For developing countries, the fact that the latest crisis occurred in the heart of the global system will be seen as a blessing. The US and other rich countries have vastly greater resources to respond to the short-run crisis, and are better equipped to work out new designs for managing the financial system. Thankfully the full range of financial innovation had not pervaded financial systems in the developing world: reserves built up since the Tequila, East Asian and Russian crises of the previous decade would have been useless to respond to the 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 likelyWe dont 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.

The author is at the Harvard Kennedy School, the Institute of Social & Economic Change, and the Centre for Policy Research