BT : Is the world heading for another recession?

Business Times - 13 Jul 2010

Is the world heading for another recession?

Asia could come to the world's rescue as the austerity drive takes hold in Europe, US

By SHAHID JAVED BURKI

IN RECENT months, economic policy around the world has taken a major wrong turn and, according to some economists, the global economy may be heading towards another recession. If that were to happen, the Great Recession of 2008-09 may turn into the Great Double-dip Recession of 2008-11.

This may degenerate into a depression, the first since the late 1930s. The main reason for this unhappy turn in events is the policy-induced weakness in aggregate demand. This is more evident in Europe but may also happen in the United States.

Deep political divisions in the United States are preventing the Obama administration from assisting the unemployed as their benefits run out. Republicans in the Senate, with some help from conservative Democrats, have blocked US$77 billion in aid to the unemployed proposed by the administration.

The German government has pledged US$100 billion in tax increases and spending cuts even though the economy continues to operate well below capacity. The newly installed Cameron-Craig government in London has also opted for austerity. The French are also pulling back sharply.

Perhaps most troubling of all is that the G-20 governments that recently met in Toronto failed to agree on a common framework for guiding the world economy back to full recovery. We know from the history of the world economy that when national governments are left to work on their own they are likely to work against each other rather than in support of one another. That happened in the period before World War II and produced the Great Depression.

Does this mean that the world is headed not only towards a double-dip recession but perhaps to a full-fledged depression? The answer is probably no because the large economies of Asia have not - at least not yet - joined the politically popular austerity drive in the countries on both sides of the Atlantic. Asia may come to the world's rescue and in the process acquire greater economic heft.

Economic downturns - their depth and duration - are exceedingly hard to predict. This is especially the case when governments actively intervene to shorten their duration and reduce their depth. Sometimes the cures that are used may worsen the situation rather than reduce the impact of the downturn. The 2008-09 downturn, by far the most severe of the several that have hit the global economy over the last six decades, was supposed to have ended by the time the year 2009 was in its third quarter.

The conventional measure - two successive quarters of growth - when applied to this downturn seemed to suggest that the recession was over. Not so, said Christina Romer, the chair of President Barack Obama's Council of Economic Advisors. According to her, she would be prepared to say that the Great Recession had ended only when the rate of unemployment in the United States declined to 5.5 per cent of the labour force. That may not happen for many quarters.

On the other hand, Larry Summers, the other important economic policymaker in the Obama White House, and US Treasury Secretary Timothy Geithner prefer the conventional interpretation. They believe that the aim of policymakers should now be to manage the recovery, determining the time when governments should begin the process of reducing the amount of stimulation used to prevent the economies from going into a free fall.

President Obama's challenge is to balance three different types of advice he is receiving from the people who work in his White House. The most vocal are those who watch politics, among them Rahm Emannuel, his chief of staff, and David Axelrod, his senior advisor.

Both are worried that given the sharp increase in the levels of public debt and associated fiscal deficits it would be politically costly - perhaps suicidal - to continue to stimulate the economy by using the printing press. Already, the 'Tea Party' movement has gained a great deal of political ground. It has developed its campaign by suggesting that the mountain of debt the United States has built up will have a severe impact on future generations as they begin to pay off the accumulated debt through higher taxes and reduced consumption.

Mr Summers and Mr Geithner are the sources of the second line of advice to the US president. They are not averse to continuing with some stimulation and providing compensation to the millions of people who remain unemployed - both positions are unpopular with the Republicans - but they also want to focus attention on reforming the financial system through better regulation. According to them, the president needs to spend his political capital on bringing about structural changes in the economy so that the economy does not go through another spin as it did in 2008-09.

The third line of advice comes from people such as Ms Romer who fear that by exiting more rapidly than the current situation warrants the economy may head towards a double-dip recession rather than continued recovery. This group has the support of some private economists with powerful credentials.

The most prominent among these is Paul Krugman, a Nobel Prize-winning Princeton professor and a columnist at The New York Times. 'Many economists, myself included, regard this turn to austerity as a huge mistake,' he wrote in a recent article. 'It raises memories of 1937, when FDR's premature attempt to balance the budget helped plunge a recovering economy back into severe recession. And in Germany, a few scholars see parallels to the policies of Heinrich Bruning, the chancellor from 1930 to 1932, whose devotion to financial orthodoxy ended up sealing the doom of the Weimar Republic.'

While both the European Union and the US are projected to see growth of only one per cent in their respective GDPs in 2010, the Asian countries are expected to do much better. Led by China, Asia is becoming the engine of global growth and may save the world economy from plunging into a double-dip recession.

Asia's help is coming in many ways. Recent German data illustrates the deep structural changes taking place in the global economy would not have been possible without economic expansion in Asia. Since May last year when continental Europe was in the midst of the worst economic downturn in the post-war period, German exports have risen 28.8 per cent.

Sales to non-European markets buoyed the trend; they increased by 39.5 per cent. 'Without China we would have hardly seen this recovery,' said Hannes Hesse, managing director of the VDMA engineering associates. According to Deither Klingelnberg, a maker of machine tools, Asian and emerging markets demand is the main driving force for the on-going recovery of German manufacturing and exports.

'It's China, China, China by a long way, then India, Brazil, then Russia - and the US remains weak, as do many of our European markets,' he said. While China may begin to slow down the unsustainably high rate of growth of recent months, growth will remain close to 10 per cent.

Some other large Asian economies may step forward. For instance, there is a lot of life in Indonesia which could begin to spend more by relying not just on taxes but also on borrowing. Emerging Asia as whole, with a quarter of the world's gross domestic product, has less than 8 per cent of its outstanding bonds.

Increasing the ratio will help not only to increase domestic demand, it could also put a floor under which the global economy would not fall. Asia then has become the economic area that will begin to carry a great deal of water for the global economy. But for that to happen, the West must not turn totally away from expansion and move towards austerity.

To use another metaphor, Asia is developing broad shoulders but they can carry only so much burden for the moment.

The writer is a senior visiting fellow at the Institute of South Asian Studies. He is a former vice-president of the World Bank and served as Pakistan's finance minister in 1996-97



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