Sunday, March 13, 2011

The trans-Atlantic debate on igniting economic recovery

When history of the Great Recession will be written, among the primary issues for discussion will be the relative impacts of recovery policies followed across countries.

On the one hand, countries like England, Estonia and Ireland have responded with savage fiscal austerity by cutting wages, spending, and even raising taxes. Across the Atlantic, the US has responded with multiple fiscal stimuluses and continuing monetary accommodation. The major European economies like Germany and France too reacted with stimulus measures, albeit much less muted. Which of these two opposing fiscal policy stances succeeded?

There are two undoubted distinguishing features of the Great Recession. One, aggregate demand has slumped as evidenced by persistently weak consumer spending and the rise in unemployment rate. Second, the balance sheets of households and businesses have been battered by the bursting of the asset bubbles.

Both require different policy prescriptions. An aggregate demand slump would require fiscal policy interventions that would provide money to those people who are likely to spend them. Direct spending measures (like infrastructure works and transfers to local governments) and social safety cushions (like unemployment insurance and food stamps) are ideal for boosting aggregate demand.

Repairing battered balance sheets require policies that help pay off debts or lower its burden or atleast reschedule them. Monetary accommodation for an extended period will lower the debt service burden. Additional credit lines will help mitigate the inevitable liquidity contraction after a financial market meltdown. Since large numbers of people are left with negative housing equity, policies that restructure mortgage debts will help repair household balance sheets. Stimulus spending by way of tax cuts will leave people and businesses with more money which can be used to repay debts.

However, balance sheets cannot be repaired in a hurry. In fact, it will take long for households and firms to shake off the massive debts accummulated. It can only be hoped that some or all of the aforementioned policies work towards helping regain much of the lost ground in asset values. In other words, policies aimed at repairing balance sheets will involve both direct efforts to reduce debt burden and indirectly buy time so that recovery will itself contribute to rebuilding balance sheets.

Both features weigh heavily on the US, British, and Irish economies - aggregate demand is weak and balance sheets of both households and financial institutions are bruised. In addition, government debts too have crossed sustainable levels. But the situation is different with much of continental Europe. They did not experience the same sort of property market bubbles like in the US or Ireland. Accordingly, household balance sheets are less a problem. Their problems lie in financial institutions with massive exposure to their own peripheral economies (the PIIGS).

In case of the PIIGS, all the three - governments, businesses and financial institutions - face deep struggles. All of them borrowed and splurged heavily during the boom and are now facing pay-back time. There is limited fiscal space available for any meaningful stimulus spending. The fiscal austerity, under implementation in some form of the other in all of them, is taking its toll on citizens.

Whatever the specific details of the policies being followed, an immediate return to robust economic growth is critical to the fortunes of all these economies. Strong growth is necessary to not only reduce the high unemployment rates, but more importantly to ensure that the share of public debts do not explode and trigger sovereign defaults.

In the circusmtances, fiscal austerity will leave the entire recovery burden on the private sector. It will have to generate enough growth to not only kick-start growth, but also cover for the loss in GDP due to fiscal contraction. And it will have to achieve this in conditions marked by persistent financial market uncertainty (with resultant high cost of capital), bruised (business and banking) balance sheets, and citizens who will face the brunt of the government's spending cuts. The odds of succeeding against these very formidable obstacles are minimal.

The initial indications from the British experience with fiscal austerity has been disastrous. After four consecutive quarters of modest growth, the economy experienced a contraction in the last quarter of 2010, declining 0.5%. This comes in the back of an extraordinary $128 bn four-year program of spending cuts and tax increases, including an across-the-board reduction of 20% in the budgets of most government departments. Ireland's two year fiscal austerity appears to be leading the country firmly down the sovereign default path. If that is any indicator, England faces a very long and painful struggle ahead.

However, there is one area where the debate about policy responses appears to have been settled. In the aftermath of the sub-prime meltdown, the US Fed and Government responded with great speed and pumped in massive amounts of liquidity to bailout the affected financial institutions. Apart from lowering interest rates to the zero-bound, these measures also included credit guarantees and unconventional quantitative easing through direct credit injections, banking reserve expansions, and asset purchases.

The Fed emerged as an effective lender and insurer of last resort. A massive $750 bn financial market bailout was followed by two rounds of quantitative easing. More than $3 trillion have beeen injected into the financial markets to drive Wall Street's recovery. And the results have been spectacular, though confined to corporate America.

Simon Johnson places the recovery in Wall Street and corporate profits in the US in perspective by comparing with recoveries in earlier recessions. The last quarter saw Wall Street back to pre-crisis levels of profits and executive compensation. The bailouts and implicit government guarantees saved the day for Wall Street. The fiscal stimulus backstopped corporate profits from falling too much. The ultra-low interest rates have kept the debt service burdens low and bought time to heal the debt-laden balance seets. He writes,

"Profits for the private sector... in the third quarter of last year... were back at the level of 2006. After the deep recessions of the early 1980s, it took at least three times as long for profits to come back to the same extent."

He also writes,

"In the back-to-back recessions of 1980-82, real non-financial sector profits dropped about 30% (from 1977-78 to 1980) and struggled to rebound for most of the decade. This same measure of profits did not surpass its level of the late 1970s until the early 1990s... during that same cycle... real profits in the financial sector fell 50% from 1979 to 1980, regaining the level of the late 1970s by 1987...

In contrast, over the finance-led boom-bust-bailout cycle of 2007-2010... profits have proved much more resilient. In real terms, the financial sector earned record profits in 2005 (and accounted for an eye-popping 30% of total corporate profits in that year). These fell sharply, to be sure, but only really for one quarter at the end of 2008. Financial sector profits have been running at around 90% of their pre-crisis level since early 2009."

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