Economic recession - Longish this time!!!

All indications are that the current global economic crisis is the worst since the Great Depression of the 1930s, in terms of geographical spread, intensity and duration. No country is spared, although some countries will feel the heat more than some others. Open economies with small domestic markets, in particular, seem most vulnerable.Growth forecasts for the world economy this year range between 0.5% and 0.9%. Many individual country GDP (gross domestic product) forecasts are negative. Economies already slipping into recession include the United States, Britain, Euro-zone members, Russia, Japan, South Korea, Taiwan, New Zealand and Singapore.One cannot rule out the possibility of these dismal numbers being revised further down before long, as the crisis is still unfolding. The worst is yet to come. Worse still, there are no quick fixes for the global slump, which means that this crisis will stick around stubbornly longer than most.

One explanation for this frightening prognosis is that this crisis does not represent a purely cyclical phenomenon of the usual boom-bust roller coaster variety, where ups and downs are dramatically swift. This crisis has been brewing for a long time unnoticed by analysts who were focused on short-term fluctuations.Serious fault lines have developed in the world economy over the years, with severe imbalances of sorts between savings and investment, production and consumption, revenue and expenditure, as manifested in widening current account imbalances and growing budget deficits, not to mention unstable exchange rates, interest rates, and asset prices.This crisis is a combination of both cyclical and structural problems. The latter require painful microsurgery, including major institutional reforms, which take time, quite unlike macroeconomic countercyclical interventions. What’s more, studies have shown that economic crises preceded by financial crises tend to drag on and on. The task for policymakers in such tough circumstances is daunting. Even the relatively easier macroeconomic policy interventions are not going to be that easy, as policymakers have fewer options.The three tools used during economic meltdowns are monetary, fiscal and exchange rate instruments to stimulate a faltering economy.

For the monetary policy, the central bank reduces interest rates and relaxes statutory reserve requirements so that banks can lend more, resulting in increased consumer spending and investment expenditure, augmenting economic growth.

Fiscally, the treasury reduces taxes and increases public expenditure at the risk of budget deficits, not only to increase the disposable income of the people so that they will spend more, but also to pump-prime the economy through increased government expenditure that will take up the private sector slack.

An appropriate foreign exchange rate policy in such circumstances will be to opt for a weaker currency, as this renders exports competitive and divert domestic demand away from imports to local substitutes.

Unfortunately, the reality on the ground now in most countries, especially the US, is that all three instruments are somewhat blunt. Interest rates are already close to zero in Japan and the US, while in many other countries, they hover at historically low levels.Interest-rate cuts will work only if rates are high to begin with and the cuts are substantial. Given near-zero interest rates, further rate cuts can only be marginal, with little impact, for nominal interest rates cannot fall below zero.In the US, real interest rates are negative, given the higher rate of inflation relative to the nominal interest rate. In a recession, inflation tends to give way to deflation, with falling prices, in which case the interest rate will rise in real terms by becoming less negative than previously, thereby raising the cost of borrowing.

In other words, the result will be the opposite of what monetary easing is supposed to accomplish.The picture is quite similar for fiscal instruments as well. Many countries, including Japan, India, Malaysia and the US, have been running large budget deficits even in good times year after year. Increased budget deficit through tax reductions and/or expenditure hikes, in such cases, may only have limited impact due to fiscal fatigue. A budget deficit of, say, 5% of GDP will have significant impact in an economy with a balanced budget, but not for an economy with a deficit of four per cent of GDP.Where monetary and fiscal measures do not work well, the foreign exchange rate mechanism can help if there are no constraints on exchange rate changes. Thus, an exchange rate devaluation or depreciation will increase demand for a country’s products at home and abroad by making exports cheaper and imports dearer.In theory, a country’s currency will depreciate in the wake of an economic slump, but this is not the case with the US dollar, which has been strengthening in recent times. The dollar is able to stay strong, despite US economic woes, thanks mainly to massive capital inflows into the country, as the US continues to borrow, with others wanting to keep the dollar strong so that they can continue to export to the US and at the same time protect their reserves from a possible collapse of the greenback.No way can the US economy recover rapidly so long as its currency remains unrealistically strong. The dollar will have to depreciate significantly for the US to produce more for exports and to divert its insatiable demand towards American products.Thus, exchange-rate corrections are needed, not only to reduce the US current account deficits but also to stimulate domestic production for both external and internal consumption. This is unlikely to happen anytime soon, however, given the global addiction to the greenback, and hence the failure of the exchange rate instrument.

With all three major policy tools- monetary, fiscal and exchange rates-under heavy sedation, the chances of a quick recovery are quite slim. The writing on the wall suggests the crisis will stick around for at least two years, if not longer.