Thursday, July 30, 2009

Global macroeconomic re-adjustments are inevitable

The irrational exuberance about "green shoots" is getting to me. There are no simple solutions to the problems that have brought the world economy to its present plight. I have written many times before here, here, here and here. In an earlier post, I had written about an essay by André Lara Resende and about the importance of restoration of financial market confidence and revival in asset values to remove the debt excesses from the financial markets.

To reiterate, a sustainable global economic recovery, one which does not inflate another bubble to recover from the previous bubble (as happened with the credit bubble in the aftermath of the technology stock bubble), would demand a more fundamental re-adjustment of global economic patterns in both consumption and savings and trade.

The present creditor nations will have to boost local aggregate demand by encouraging its consumers to spend more. Further, they will also have to broaden and deepen their financial markets to provide more avenues for domestic lenders/investors to invest their monies. And these government will have to refrain from currency manipulations which not only keeps their exports artificially competitive but also makes imports expensive for domestic buyers. And it also puts pressure on Central Banks against moderating, leave alone loosening, monetary policy even in response to loose external credit environments.

For the debtor nations and its consumers, businesses and governments, the adjustment will have to be more profound. Despite the paradox of thrift, they will have to encourage their citizens to save more and consume atleast a little less. These governments will have to facilitate their businesses to export more. But more importantly (and this has been side-stepped in much of the discussion surrounding rectification of global macroeconomic imbalances), it is imperative that financial markets be better/tightly regulated so as to ensure that there are no easily available irresistable arbitrage opportunities.

This in turn means that the loose money policy has to be reined in as soon the economy starts its recovery. However, this comes up against the widely help opinion that the Japanese recovery in late nineties in the aftermath of the bursting of the real estate lending bubble and first round of pump-priming through government spending was nipped in the bud by the failure to maintain monetary policy loose. In the present case, a delicate trade off will have to be done between the two conflicting results of tightening the monetary policy - on the positive side, preventing financial market distortions with its attendant longer-term consequences, and on teh negative side, squeezing growth and recovery by both raising the cost of capital for businesses and increasing the debt burdens on the mortgage holders and other retail debtors.

Achieving a delicate balance between these two, while following a relatively tighter monetary regime, can be achieved with a dose of inflation - which by reducing the real debt burden, can help alleviate some of the pain - and controlled devaluation/depreciation - which adds to the health of the external sector. But the pitfalls are that both leave open the possibility of uncontrollable inflation and devaluation spirals.

It is futile to hope that extremely loose credit policy, fiscal spending and extraordinary expansion of the balance sheets of the Fed can ensure a return to the Great Moderation age of the last two decades. A long period of pain, similar to the Japanese experience, is inevitable. The challenge is to manage this transition with the least possible damage. Normalcy cannot be restored without undergoing this transition. And all this means a long drawn out, L-shaped, recovery during which the pain of re-adjustment will be felt by different stakeholders. And this process of recovery will considerably eased if confidence can be restored to the financial markets and asset values start their recovery.

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