Getting out of low-growth trap: Economic Times, 15th October 2011

If one were a student of Economics in the last five decades or so, there would definitely be some inclination towards either John Maynard Keynes or Milton Friedman. Acrimonious debates have typified discussions by these schools with each one often claiming that the other is only a special case of their own line of thought. But today, ironically, we have a situation where governments and monetary authorities are asking the other to take affirmative action as they do not have a solution.

The world economy is in a fragile state now. The quick recovery from the financial crisis through monetary easing and Keynesian spending was assumed to be the beginning of a new era of prosperity, but the euro region crisis has elevated the crisis from the financial system to sovereign failures. Let us look at the US first. The Fed took it upon itself to resuscitate the economy after the financial crisis and what followed were rounds of quantitative easing: QE1 and QE2. The basic idea was to provide liquidity to the system at a time when banks did not trust one another. Interest rates were lowered to almost zero to encourage spending. Yet, growth is sluggish and could be around 1.4% this year with unemployment rate closer to the double-digit mark.

This is what Keynes would have called the liquidity trap where interest rates reach a plateau and don't matter. The solution is for the government to spend. But the government cannot spend as debt levels are too high and it has just gotten away from a possible theoretical default and raked up controversy over the downgrade . Fiscal solutions are weak. The euro region has a different set of problems as it is a combination of 17 countries. Fiscal deficits in the rogue nations have spoilt the party, and the ECB, Germany and European Financial Stability Fund (EFSF) have pooled in resources and support along with IMF to help them out.

The problem here is the high ratio of debt-to-GDP . Greece tops with over 140%, followed by Italy with 120%, and Ireland and Portugal with over 90%. Governments are being asked to follow austerity as they have built up large levels of debt that will be hard to service. This has meant that governments have to cut expenditure and raise taxes , which is deflationary as the countries slip into a recession that will exacerbate the deficit. The ECB has to risk inflation by lowering rates, as this is the only way in which it can lower the cost of borrowing in a region where there is general 'trust deficit' . But lower rates will help to lower credit default swap rates for governments as well as private bond rates. Keynes will not work here and the ECB has to look closer at the inflation tradeoff.

Amid such a scenario, there is a new brand of Economics that has come to fore, Regulatory Economics, which will further impede the growth process . Following the financial crisis, Basel-III is on the anvil, which though will be implemented over a period of time (spread during 2013-19 ). It will tighten the requirements for capital (tier I) and liquidity, both of which were the main issues at the time of the financial crisis. This means that banks today are even more reluctant to lend as they shore up their capital and liquidity. This has been the issue in the US where low interest rates do not inspire lending as banks have to attend to these requirements. The western nations are, hence, definitely in a difficult state where policy application is a challenge .



How about the developing countries ? Here, the issues are different. While growth in countries like India and China is still strong, the problem of inflation remains with central banks furiously pursuing aggressive monetary policies. This has, in a way, put brakes on the demand for credit that is expected to slow down the pace of overall growth. Therefore, once again, there is a downward thrust on growth as central banks counter consumer inflation rates of 5.4% in China, 8.6% in India, 9% in Russia, 6.9% in Brazil and 5.3% in South Africa.

These governments have embarked on a policy of fiscal stimulus rollback and can look in only one direction: reduction of deficits. Hence, if no affirmative action is taken , then the slowdown can degenerate into a recession that will be slow and painful. Presently, no one wants to appear playing truant as Trust Economics has come into vogue. The solution is really for every entity to give in a bit and accept a tradeoff. US should continue to spend to provide demand notwithstanding its debt - sounds heretical after all the ado about the downgrade - as we need some benign neglect to revive the global economy.

ECB must lower rates for whatever it is worth. China should be more responsible and help foster global trade through exchange rate adjustments and other emerging markets must spend to keep business up. In short, both Keynesianism and monetarism should be pursued as 'deviant fiscal behaviour' , and inflation is better than prolonged stagnation.