This series on the global crisis concludes by asking: What will happen when recovery resumes? What lessons for global economic and financial management will have been learnt? What will be the prospects for growth, inflation, financial system restructuring and regulation?
The consensus now is that the money being thrown (wasted?) at reviving global demand and repairing bank balance sheets in the three years 2008-2010 will exceed: (a) US$9 trillion in incremental fiscal deficits around the world; and (b) US$12 trillion in aggregate monetary loosening by global central banks, some of that going to finance incremental public deficits. With global GDP shrinking to a nominal US$50-51 trillion by end-2009, those are not trivial sums. It is difficult to imagine markets absorbing the full amount of additional public debt that governments will issue. Much of it will be monetised through direct central bank purchases.
That may not show up in inflation now. But it must in the not-too-distant future; despite those who mock such a prospect by accentuating the imminent risk of deflation. Allowing for a proportion of new money being absorbed by value losses in bank balance sheets, there will be an overhang of liquidity waiting to circulate in the global economy with increasing velocity as consumption revives. Excess liquidity will not be quite as easy to withdraw as it was to emit. The timing of monetary and fiscal tightening will be crucial. Too soon and recovery will be compromised. Too late and high inflation will be unleashed. What timing would be exactly right? No one knows!
But all that is theoretical. The crisis will be prolonged indefinitely if: (a) governments around the world keep fumbling, indicating to markets that they are clueless and helpless; (b) fiscal stimuli are as poorly designed and misdirected as they are; (c) toxic assets, whose value cannot be determined, remain on bank balance sheets, without being transferred and quarantined in a plurilateral asset resolution corporation (PARC) of some kind, on appropriate terms; (d) the drift towards de facto or de jure bank nationalisation , resulting from relentless ?de-capitalisation?, continues unchecked, resulting in global banks ceasing to function, shrinking their operations precipitately, and being run by emotional legislatures instead of professional managers; and (d) urgent economic, financial, institutional, and regulatory, reforms in OECD countries and Asia (especially India and China) are deferred using the crisis as an excuse. Unfortunately, all five of these trends/conditions look like they will continue rather than being contained or reversed.
But, justifiable concern aside, it seems unlikely that the world economy can continue contracting at the extraordinary pace of Q4-08 and Q1-09. That implosion has taken even the most pessimistic analysts by surprise. No one expected Japan to contract at an annual rate of 12% or Korea at 21%. Following the vicious wring-out that has occurred, the world economy is likely to contract more moderately from Q2-09 to Q4-09. As supply chain de-stocking, cutbacks in corporate investment, and household consumption deferral/compression, all run their natural course, seriously flawed fiscal stimuli will begin to take weak effect, with the global economy bottoming by Q1-2010. But the recovery will be so fragile as to be almost indiscernible until Q3-2010.
While that trajectory may apply to the world, India?s growth will probably slow further from 5.3% in Q4-08 to 4.5% in Q1-09 before recovering to 5% in Q2-09. What happens thereafter depends on the outcome of the general election. If the UPA resumes power, growth will probably recover to around 6% for the rest of 2009. The BJP?s leadership indulges in the bizarre belief that India?s economic crisis is piffle compared with the importance of building a Ram Mandir at Ayodhya. That gives faith a new dimension that rational economists remain unaware of. If the election outcome results, improbably but not impossibly, in a third front victory, a growth rate of -5% might be on the cards?because private investment, and confidence in India?s future, will dry up completely.
Whatever happens, it will take monetary management of extraordinary intuition and brilliance to avoid a global inflation rate of over 10% between 2011-2015; bringing to mind a period in 1981-84 when Paul Volcker had to raise the Fed rate to over 15% to bring inflation back under control by 1986. The crisis has, understandably, resulted in more words being written than ever before examining every aspect of it?s unfolding in minute detail. Yet, the question remains: what lessons will we have learnt? None that will prevent the next crisis from occurring!
There are serious lessons to be learnt about financial system regulation. But if one analyses what is being said it seems likely that the wrong lessons will be imbibed, not the right ones. This crisis makes a powerful case for unified systemic financial regulation by an authority independent of the monetary authority, and for principles-based regulation that is properly and rigorously enforced. It was in the US with fractured, uncoordinated rules-based regulation that the worst excesses and damage occurred. The crisis also makes a case for seamless, high-level coordination across fiscal, monetary and regulatory authorities; especially when it comes to bolstering financial firms experiencing liquidity distress, without heeding concerns about moral hazard in the midst of a crisis. Yet, if you heard the retrospective musings of the UK Chancellor about regulation, as well as the reactions of traditionalists opposed to any financial regulation other than that imposed by a central bank (which is incapable of regulating capital, insurance, derivatives or commodity trading markets), you would get the opposite impression. Much can be said about this. But this is not the place to indulge in technical detail; except to hope that sense will prevail over obduracy.
Similarly, one would hope that lessons will be learnt from the credit default swap (CDS) market that a clearing counterparty is urgently needed for intermediating such swaps to maintain the integrity of counterparty performance. Lessons need to be learnt about adopting countercyclical capital build-up policies for banks, and for risk weighting of capital requirements for bank portfolios. Basel-2 was clearly a failure despite the monumental effort that went into it. Similarly, we need to revisit implicit policies permitting banks to become too big to fail. By now we should have learnt that asset prices matter. Permitting the build up of asset price bubbles is a dangerous risk for central banks to take. Greenspan was wrong about that. We need to learn (from the Euro and EU) that a unified fiscus with seamless intra-regional fiscal transfer mechanisms, along with a unified financial system regulatory authority, are essential concomitants for maintaining the credibility of a synthetic currency, especially in times of acute stress.
But the most important of lesson of all may be one that is obscured; ie. that issuers of global reserve currencies need to be subject to tougher global surveillance over their fiscal and monetary policies and to rigorous monitoring, enforcement and sanctions by multilateral agencies. Another lesson that won?t be learnt is that the world needs India and China to put their currencies on the world stage as prospective reserve currencies. That is to avoid the future concentration of global reserves in currencies whose long-term credibility is suspect. The issuers of those currencies are focusing exclusively on meeting domestic concerns, rather than acknowledging the legitimate concerns of those who hold those currencies around the world as media of exchange and stores of value.
These and countless other lessons are waiting to be learnt. But until the crisis is over and recovery resumes there will be no appetite for learning or applying them. Moreover, as in India, die-hard traditionalists will use the crisis to reinforce entrenched biases, their faith in idiocy and heterodoxy, and in command-control, rather than learning from experience and changing their views as facts and circumstances change. Their unshakeable prejudices will remain more important than evidence. The lesson to be learnt there is to ignore their views and their advice!
?The author is an economics and corporate finance expert