Think of the financial crises we are more familiar with. These typically affect one country or a group of countriesJapan or Sweden at the beginning of the 1990s, Mexico in 1995, Indonesia, Korea, Malaysia and Thailand in 1997, and so on. These crises have common features. The financial sector runs up a lot of bad assets, theres a lending collapse, a generalised fall in aggregate demand, and a cycle of worsening asset quality and profits in the corporate sector that further hurts the financial sector. Emerging markets get an additional hit from a flight from the currency. If there is fiscal spaceas in Japanfiscal expansion moderates, but doesnt prevent, macroeconomic decline. If there is no fiscal spaceIndonesia or Mexicofiscal cuts add to the contractionary brew. So how do countries get out of this There is painful restructuring in the corporate and financial sectorsall too often with ill-designed, regressive bailouts. The real exchange rate falls and this increases competitiveness, and, sooner or later, growth restarts.
Escape is greatly helped by favourable global economic conditions. Most importantly exports take off. Often foreign capital comes into purchase banking and other assets, rendered cheap by the crisis. That may be unsavoury on distributional rounds80% of Mexicos banking sector was sold to foreign bankersbut it helps restore the financial sector to health.
But the current crisis is truly global. Exports in January fell by 46 percent in Japan and 18 percent in China, compared to the previous year. Indias exports were down about 10 percent in the last quarter of 2008. Manufacturing sectors are declining in much of the world. A big part of the crisis in every country is lack of aggregate demand. Investment is falling sharply owing to the combined effects of declines in sales and profit expectations and the financing squeeze. Consumption is declining as households fear job lossesand in the US and other bubble economiesare increasing savings to restore their balance sheets. But this time there is no way out via demand from external markets, for decline is happening everywhere. There are few buyers for risky assets at bargain prices.
Now add to this the difficulty of synchronising policy responses. Three things would help: a coordinated international fiscal stimulus; financial sector re-regulation; and keeping markets open. All of these look problematic. While a global government would run a global fiscal stimulus, there is an asymmetry: countries without fiscal space cant increase a deficit, while those with fiscal space are unlikely to run the extra-large deficits required to offset this, owing to fears of future debt problems. The excessive prudence of Germany and like-minded countries is a further problem. Financial sector re-regulation is likely to stall on conflicting views, and global financial regulation is in any case undesirable if it means inappropriate regulations for emerging markets. Last but not least, real sector policy is focused on helping domestic firms and jobs. Even if overt trade protectionism is held at bay, there are plenty of other ways of giving preferences. This is a classic collective action problem: each country stands to gain by keeping its markets fully open, but only if everyone else does the same!
In principle, international political coordination can solve these collective action problems, but this is truly hard, because politics is intrinsically local. European and US politicians are unlikely to campaign on protecting Chinese and Indian jobs when workers are being laid off in Toulouse and Detroit.
What does this imply Things could be bad for some time. A quick recovery in late 2009 or 2010 looks implausible. Eventually some recovery will happen, as deleveraging occurs, financial systems resolve, consumers restore their balance sheets and asset prices find their floor. But this looks like a very, very different environment from the past decade. In terms of domestic policy, this means a focus on what can be done in a highly constrained environment, both in terms of shielding the vulnerable, and undertaking the fiscal and economic restructuring that will support productivity growth in the medium and long term.
I really hope that this assessment is too gloomy. But it would be imprudent to design policy around hope. Delaying action will only worsen eventual costs for households and firms. The politics of this is another story.
-The writer is at the Harvard Kennedy School, the Institute of Social & Economic Change and the Centre for Policy Research