Tuesday, February 26, 2013

When all theories collapse...Business Standard 9th February 2013

Countries have to carve their own paths to growth because conventional notions no longer hold

The ideas of economists and political philosophers – both when they are right and when they are wrong – are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.”— J M Keynes
Ironically, when we see policy makers struggle to find solutions, this quote strikes us, because none of the theories are working today.

The first defeat is of Keynesianism. When economies are down, Keynes would suggest pump-priming. But two things are happening. The first is that countries are already running high fiscal deficits like the US (seven per cent), the UK (7.9 per cent) and Japan (9.8 per cent). Quite clearly, high deficits have not really helped. Resolution of the fiscal cliff will only add to the pressure of a recession. The problem has been deferred and not yet solved, but either tax enhancing or expenditure cuts mean less of fiscal policy. The second is that the euro zone has to cut down on government expenditure, which means that fiscal austerity is the way forward. The outright monetary transactions (OMT) programme is based on countries sticking to the fiscal austerity path. Clearly, Keynes is forgotten.

The second is that monetary policy also ceases to matter. Interest rates have been lowered to the extent that they cannot go down further. Yet, economic activity has not picked up. Keynesians would call this the liquidity trap when lower rates do not inspire borrowing. The governments have tried to move the money supply curve up through various versions of quantitative easing (QE), going under different names. We had the QE sequels while the European Central Bank used the longer-term refinancing operations (LTRO) and OMT to induce liquidity. Monetarism has not worked, since deleveraging is on and banks do not want to lend.

Third, in this process of downturn in economic activity, a new area that has developed is “Trust Economics”. Both the financial and sovereign debt crises have one underlying commonality — the loss of trust. In the financial crisis, banks stopped dealing with others and even short-term loans became scarce. No one knew how good the counter party was. Money had dried up owing to the fear of toxic assets, as collateralised debt obligations and credit default swaps came to be called. In case of the sovereign debt crisis, countries have stopped trusting one another and banks are holding debt of sovereigns that cannot be serviced.

Fourth, it was always felt that China and India would continue to grow upwards because there was no alternative route. China has slowed down because its basic model is now being questioned. Can an economy grow on the basis of high investments and not consumption? Building flyovers and expressways is one thing, but we need vehicles plying to make it worthwhile, for which incomes have to increase. For India, we spoke of a possible double-digit growth and suddenly high inflation, peculiar to our country, has shattered such illusions. The slump cannot really be attributed to the global slowdown, but we have reached the end of the climb and require a new mindset to move ahead.

Fifth, while the theory of decoupling has been said to be the reason for global growth in the past, it no longer holds. When the financial crisis came in, it affected the US, and Europe was insulated to a large extent. The UK had its shock element in Northern Rock Bank, while it was business as usual for the emerging markets. But now with the euro zone going into a recession and the US stumbling, the export oriented emerging markets are in for a setback. It is not possible to shunt the wagons easily now.

Sixth, a global slowdown, if not a recession, should be bringing down commodity prices. But this is not happening. While metal prices have come down, farm products continue to be volatile, while the oil story is hard to explain. Typically, oil prices should come down once there is a recession in any major economic block. Post financial crisis in 2008-2009, oil slipped down towards the fifties. But this has not been replicated this time. Maybe it is the weak dollar, but we are all paying more for oil.

Seventh, with the euro crisis on, the dollar should have been strengthening. But given the inherent weakness of the US economy, the dollar has been under pressure, thus leading to considerable volatility in the exchange rate. Besides making global markets shaky, it has affected exchange rates across the world.

Eight, on account of exchange rate instability companies have not been able to take advantage of low interest rates in the developed economies. Usually interest rate variations lead to “carry trade” where one borrows in countries with low interest rates and lend where rates are high. Such arbitrage opportunities have gotten reduced through exchange rate risk.

Putting everything together, there appears to be several antithetical economic currents, making it hard to use conventional tools. Conditional monetary resuscitation packages mean governments don’t matter, while the liquidity trap makes central banking challenging. The solution has to be through markets, which are in a confused state. While it is not a 1930s-like situation, the inherent complexities make the recovery process that much more gradual. Owing to strong linkages through globalisation, no country is left out, and the pain is pandemic. Countries have to wean their own ways unlike the 2009 situation where the rebound was as quick as the fall.

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