Sticking to fiscal targets in the middle of a global slowdown could be dangerous, says Abheek Barua
The aversion to regulation, the reluctance to even recognize the existence of bubbles in asset markets and a sledgehammer approach to monetary policy are dogmas that underpinned economic decision-making through much of 2008. These have led to the worst economic crisis in recorded history. It is thus imperative that we jettison them.
I see another bit of ‘conventional wisdom’ beginning to impinge on economic policy, both in the US and in India. This argues against the use of public money to prop up aggregate demand and is misplaced. Trying to balance the government’s books when business is as usual might be fine. Sticking to fiscal targets in the middle of a global slowdown could be dangerous.
Let me ease up on the polemic and explain why I see the current economic crisis as the outcome of a series of policy botch-ups that were made as recently as October. The National Bureau of Economic Research (NBER), the official arbiter of booms and busts in the US, has now declared that the American economy has been in recession since the end of 2007. If a similar exercise was carried out for Europe, it is likely that it would arrive at similar conclusions. China’s severe slowdown is now getting reflected in headline data as is India’s. I suspect that the inflexion in their business cycles would have been visible much earlier. There is general agreement on the causes of this sharp downturn — the financial crisis that gripped US financial markets from mid-2007 and has spilled over to the global ‘real’ economy.
The financial crisis, in turn, has been blamed on lax regulation of banks and irresponsible monetary policy over the past decade (or longer). While this prognosis is correct, I would argue that policy-makers across the world made a new set of mistakes in 2008 that exacerbated the crisis and tipped the world economy into recession. If these errors and missteps had been avoided, the impact of the US crisis would have been more limited. Of these, the rapid increase in policy rates in both the developed and the emerging markets has to take the biggest share of blame.
Let me explain. By the end of 2007, it seemed clear that US growth was decelerating rapidly and would, most likely, start impinging on growth in the rest of the world. Yet, despite these fears of growth, almost all non-US central banks either hiked policy interest rates or refused to pare them. Monetary policy tightening in the face of an impending slowdown aggravated the problem and has ultimately led to a full-blown global recession. Here is an example. Europe today is staring a deep recession in the face but as recently as July 2008, its central bank was pushing up its benchmark rate. The fact that Europe’s recession is being led by plummeting investment demand (typically the most interest rate-sensitive component of overall demand) underscores the role of rising cost of money in the downturn.
The reason for the tight money regime of 2008 was of course high inflation that rode on the back of commodity prices, particularly oil. Monetary policy rhetoric made it clear that in the war on inflation, growth would and should get short shrift. This seemed sensible — inflation is known to take a quicker and bigger toll on households, particularly the poorer ones, than any other economic malaise. The problem, however, did not lie in governments’ decision to fight inflation; it was their identification of the causes and the choice of weapons that went horribly wrong.
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Let’s start with commodity prices. The fact that oil prices have corrected (dropped to less than a third of the peak levels seen in July 2008) suggests that prices were indeed driven up primarily by speculative investments and not growing demand-supply gaps. (This is not to deny that there are indeed some structural imbalances in demand and supply; prices had however moved up way over the levels that the demand-supply gap would suggest.) Monetary authorities failed to or chose not to recognize this. This leads to the obvious question. What could they have done if they had at least recognized the fact that the spurt in commodity prices was a liquidity-fuelled asset bubble? I would argue that a coordinated action between American and European regulators (central banks and exchange regulators together) to regulate the flow of speculative investments in commodity markets could have done the trick. If tighter regulation rather than tighter interest rates had addressed the problem, then global growth would perhaps not been hit as hard.
Let’s give central banks the benefit of the doubt. Perhaps for things like food, a demand-supply imbalance rather than speculative positioning were pushing prices up. However, these imbalances were driven by supply shortages rather than expanding demand. A severe and prolonged drought in Australia had, for instance, impaired rice production severely. Central banks did not seem to be bothered by the causes of price escalation. In the new orthodoxy of monetary policy the sole cure for inflation was higher interest rates and tighter money. This resulted in a peculiar situation where households not only had to contend with higher oil and food prices but also with higher costs of servicing their loans. Consumer demand contracted as a result and added to the toll that high interest rates were taking on investment demand. I am not suggesting that governments could afford to watch passively as food riots broke out. Higher food subsidies or direct income support were the right answer to the problem — not higher rates.
I will end by getting back to the fiscal expansion debate and quote Paul Krugman’s New York Times column: “People who think that fiscal expansion today is bad for future generations have got it exactly wrong. The best course of action….is to do whatever it takes to get this economy on the road to recovery.”
The author is chief economist, HDFC Bank. The views here are personal