For several weeks leading up to December 31, 2012, the attention of global financial markets was almost exclusively focused on the US and its attempts to deal with the impending fiscal cliff. As it turned out, the fall was averted by way of a last-minute compromise on tax increases. More recently, US lawmakers have shown their intent to address the other problem of the debt ceiling being reached. The threat to global financial instability from political gridlock in the US appears to be receding. It is time to refocus attention on the larger global picture and assess the changes that have taken place in terms of their implications for global economic and financial prospects.
Overall, it would appear that things have improved over the past few months. After the resolution of the Greek sovereign debt situation late last year, there are no signs yet that the arrangement is under threat. Borrowing costs of the fiscally vulnerable countries have come down quite sharply, indicating that investors have become less nervous. The new government in Japan is promising stronger monetary stimulus. The Chinese business cycle appears to have bottomed out. All these factors have reinforced the developments in the US in stabilising global financial markets.
So, has the global economy turned the corner? Will 2013 represent a decisive break from the uncertainty and turbulence of the past three years? Perhaps it will. Strong upward momentum in financial markets does exert a pull on the real economy as investment motivations and wealth effects kick in. On the other hand, the depth of the trough that the global economy reached suggests that a lot more than these momentum drivers is needed for a sustained recovery. Three factors will play an important role in resolving this question.
First, there is the issue of unprecedented infusions of liquidity into the global financial system by the world’s central banks. What began as a response to a potentially devastating shock in 2008 has now become a no-alternative instrument in the face of any signs of financial or macroeconomic instability. Unquestionably, liquidity is a great comforter for financial markets, but its impact on real economic activity is difficult to predict. The old saying “you can take a horse to water but you can’t make him drink”, which has often been used to characterise the unpredictability of monetary transmission, clearly applies here. Low interest rates and abundant availability of funds may be necessary, but are certainly not sufficient, to induce a sustained increase in demand.
Particularly, when there is significant idle capacity across the world in many sectors, as well as in labour markets as reflected in the high unemployment numbers that many economies are reporting, the beneficial effects of low-cost funds could well be neutralised by higher risk perceptions for both businesses and households. If future cash flows are less certain, upfront commitments are more difficult. In other words, there are still many negative factors playing on private demand, which will weaken the transmission from financial markets to economic activity.
And public spending simply cannot come to the rescue this time. Most governments are struggling to reduce their fiscal deficits at a time when many observers believe that they should be doing exactly the opposite in order to provide whatever stimulus to demand that they can. Analytically speaking, this is an open question. Whether fiscal consolidation results in a net decrease or increase in aggregate spending depends on the sign of the so-called fiscal multiplier. If this is negative, it implies that lower government spending creates more space for private spending to kick in, even more than proportionately, which actually provides a demand stimulus even as the government spends less. This is, indeed, a fundamental premise in the fiscal contractions that the advanced economies are engineering. If it is a valid premise, things could turn out as desired. If not, and the arguments made earlier provide some basis for this concern, it is difficult to see what the drivers of the recovery might be.
Second, we do know that a recovery can be induced by a positive supply shock, that is, costs of production go down because input prices decline or productivity increases. Energy prices are clearly not helping in this process. However, evidence from Europe in particular and from other advanced economies as well suggests that wages have been declining steadily and significantly. If labour costs are declining sharply, the costs of everything should also do so, inducing more goods and services to be consumed from given levels of income.
However, there is a significant caveat here. If household incomes are going down because of wage decreases, the only way in which aggregate spending levels will remain constant is if savings decline in tune with falling incomes. Households may indeed be saving less and drawing down on past saving in order to maintain standards of living. But this cannot continue endlessly. Given the current state of unemployment, the probability of prolonged unemployment is quite high for most people who have already lost their jobs. It is inevitable that they will adjust their lifestyles and expenditures to accommodate this prospect.
What about export demand? Declining wages is a source of increased external competitiveness. But if this is happening across many countries, each one is not gaining in terms of its relative position. Further, given global demand conditions, the impact of lower wages on exports is probably more than offset by the relatively low level of demand.
Third, emerging from these concerns is the question of policy space. There is little room for conventional monetary and fiscal policies and the impact of liquidity on economic activity is yet to be proven, particularly when the overall macroeconomic situation is negative. Wage declines will help, but they cannot go on beyond a point. They are unlikely to fall to a level that will eliminate unemployment. Consequently, their benefits in terms of lower costs may be offset by their impact on household demand.
So, what does all of this add up to for the global economy? One, things have improved, but financial stability is no guarantee of sustained recovery. Two, the demand and supply adjustments needed for a sustained recovery are probably somewhat larger than what the global economy can collectively generate. Three, there are no apparent buffers against another large shock. If this were an airplane, seat belts are best kept fastened.
The writer is former Deputy Governor of the Reserve Bank of India. These views are personal
