The challenge facing the world economy

The US treasury and the Fed have effectively pumped in more than a trillion dollars over the past three months, even as the Fed's balance sheet has ballooned to nearly $3 trillion from below $1 trillion. Central Banks have indulged in monetary easing on an unprecedented scale, so much so that interest rates are staring against the zero rate bound in many of the developed economies. The Reserve Bank of India (RBI) alone has injected liquidity of more than Rs 300,000 Cr into the banking system over the same period. Fiscal stimuluses have come in all shapes across the world. None of these dramatic fire fighting measures, many of them last resort efforts, appear to have had any effect in reining in the terminal decline towards a deep economic recession across the world. What is the problem?

The bursting of the sub-prime mortgage bubble has left the financial institutions with large and unknown quantities of assets of dubious quality or troubled assets. The inability of the market and its institutions to locate, quantify, and price risk has unleashed a massive problem of information asymmetry with attendant adverse selection issues. Uncertainty about the quality of their own assets, wariness of counter-party risks in their prospective borrowers, and entrenched expectations of a deep economic recession looming have forced lending institutions to instinctively shut their lending taps and sit tight by investing their surpluses in the safety and liquidity of Government securities.

The beating taken by asset markets - equity, debt and real estate - and increased debt service burdens has resulted in a negative wealth effect (more so in the developed economies, with their low savings and income effect driven consumption) on consumers, who have abruptly reined in their consumption. The fast emerging deflation scenario and rational expectations of a deep recession have magnified this fear in consumers, who now prefer to adopt a wait-and-see approach.

When consumers shut shop and the credit markets freeze, the businesses are invariably affected. Businesses have been battered from both supply and demand side. Throw in the bleak economic prospects and they need no more signals to cancel or postpone their investment decisions. The economy gets trapped in a vicious cycle.

In many respects the specific economic and financial market conditions that created the crisis, bad as they are, have been overtaken by the psychological apprehensions and fears of the market participants. The increasingly entrenched rational expectations of the investors and lenders, consumers and businesses about themselves, others and future prospects, have brought all normal financial and economic activity to a virtual standstill. The challenge is to break this grid-lock and get economic normalcy restored. The next post will explore what the prevalent macroeconomic theories tell us about the road ahead.