Liberal opinion holds that the international monetary and financial system is a device for promoting…
The Permanent Crisis C.P. Chandrasekhar
For a world locked in a crisis, August 2011 was a particularly bad month. Economic indicators relating to different locations in its more developed regions suggested that close to four years after the onset of the global recession in December 2007, the world economy that had not fully recovered was set to sink again.
Two developments-one in the financial realm and the other relating to the real economy-were particularly ominous. To start with, for the first time in history, a rating agency (Standard and Poor’s) had downgraded US Treasury bonds from their hitherto unassailable AAA (or risk free) status and even placed them on watch for further downgrade. Official analysts and some independent observers were quick to rubbish the assessment from S&P, an agency with a poor record of predicting fragility. The assessment was even shown to be based on wrong numbers. But the fact that the debt of world’s most powerful country that was home to its reserve currency was even considered to be of suspect quality was telling.
The other disconcerting development was the release of evidence that the strongest economy in the rich nation’s club-Germany-was losing all momentum, registering a growth rate of just 0.1 per cent in the second quarter. This came at a time when the news from elsewhere was depressing. Recovery from the recession was known to be sluggish in the US. Japan, that had been experiencing long-term stagnation, had been devastated by a wholly unexpected exogenous shock. And, France had announced that it had experienced virtually no growth in that quarter. The real economy crisis had penetrated Europe’s core, pointing to the possibility of a return to recession in the Eurozone as a whole (with 0.2 per cent growth).
Even before the news from Europe had been officially declared, the nasty standoff involving the Republicans and Democrats over the debt ceiling in the US had obviously unnerved markets. The week ending August 5 was the one of the worst since the onset of the financial crisis, with the FTSE 100 falling by 10 per cent. Confidence has hardly reversed since then with investors wanting to flee from the markets but not knowing where to go other than into gold, prices of which had already soared. Over the week ending August 14, the collective outflow from equity funds was $26.1 billion, while that from bond funds totalled $10.4 billion.
Underlying this panic were four factors of particular significance. The first was the evidence reported above that the still-feeble recovery from the crisis across the developed world was slowing. This was adversely affecting growth in the more buoyant export-dependent developed countries such as Germany and threatening growth in developing countries such as China. Even when growth was occurring in the emerging markets, offering a counter to developed-country stagnation, it was leading to inflation. This is necessitating an increase in interest rates and the contraction of government spending, with adverse implications for future growth. With the resulting threat of a global double dip, confidence was bound to wane, leading to volatility in the financial markets that had just been bailed out by governments and central banks from the collapse induced by the crisis.
The second problem, at least from the point of view of financial investors, was that this long drawn effort to bail out a financial system that had speculated its way to crisis had resulted in a substantial increase in global debt. According to a calculation made by the McKinsey Global Institute, as a result of a combination of financial sector bail-outs and stimulus spending, the total amount of debt incurred by governments across the world rose by a staggering $25 trillion to $41.1 trillion over the decade ending 2010. What seemed comforting was that on average it amounted to just 69 per cent of the global GDP. But in individual countries, such as Greece and Italy, for example, debt-financed spending had indeed taken the net debt-to-GDP ratio to levels as high as 152 and 101 per cent respectively.
In some instances when slowing growth reduced revenues, concerns about the ability of these countries to service debt emerged. Till such time as there was confidence that the stronger countries in the Eurozone would back these economies with funding in the event of any financial difficulties, banks and financial investors ignored these concerns. But when it became clear that such backing had its limits, bond prices fell, interest rates rose and the willingness of financial agents to roll over past debt waned. That made it even more difficult for these countries to meet their commitments. This was when the threat of sovereign default in the developed world seemed real.
Consider, for example, the problem in Greece. The government had indeed accumulated excess debt to sustain growth and meet welfare expenditures. The private sector that had financed that debt has suddenly turned wary, and is willing to lend more, if at all, only at exorbitant interest rates. When the IMF and some European governments provided a modicum of support more than a year ago, it was in return for severe austerity measures that limited growth and reduced revenues, making sovereign default a real possibility. Not surprisingly, more than a year later, the Greek crisis has intensified.
What is alarming is that the problem in Greece or Portugal, in the Eurozone periphery, is not staying there. Despite the fact that economic conditions or the debt problem is nowhere as serious in countries such as Italy and Spain, which happen to be the third and fourth largest economies in the zone, Europe like Southeast Asia at the end of the 1990 is overcome by ”contagion”. The collapse of confidence and the fear of a sovereign default has touched these countries as well, resulting in a spike in the interest rates their governments have to pay for additional borrowing.
In fact the problem has now afflicted France as well, with Sarkozy having had to recall key ministers of his cabinet from holiday, to find ways of assuaging market fears that French debt would be downgraded because of a large deficit. The value of shares in French banks collapsed due to fears that the downgrade would adversely affect their balance sheets.
This has led to the third of the difficulties confronting the global economy. This is that government bonds are now not an automatic safe haven to which investors can retreat without blinking. An ideological backlash against public debt had send out (wrong) signals that had made investors in sovereign bonds of countries with even reasonable public debt to GDP ratios jittery. Consider for example government bonds issued by the US, which is home to the dollar, the world’s reserve currency that is still nearly as good as gold. Even for those infused with an unthinking dislike for government borrowing, US public debt is by no means too high relative to its GDP to warrant excessive concern. There are at least 10 advanced economies, from debt-strapped Greece to conservative Germany, that record a higher net debt-to-GDP ratio.
There is no real fear of US default. The stand-off between the Republicans and the Democratic administration over a routine decision to raise the Congress-mandated ceiling on public debt stemmed from another source. It resulted from the Republican objective of extracting a cut in the fiscal deficit and ensuring that it was realized through spending cuts that hurt the poor and middle classes rather than tax increases that touched the rich. In the last-minute ”deal” that was struck, President Obama was authorised to increase the debt limit by at least $2.1 trillion, on the conditions that there would be an immediate cut in spending so as to reduce the deficit by $1 trillion and that a bipartisan committee would identify ways of further cutting expenditures so as to realise an additional $1.5 trillion reduction in the deficit. Despite this, Standard and Poor’s decided to go in for an irresponsible downgrade supported with wrong calculations, only because it had decided that a $4 trillion reduction in the US fiscal deficit was needed for debt sustainability. The Republicans had managed to extract ”only” the promise of a $2.5 trillion reduction. S&P was not acting on its own. It was merely reflecting the opposition of finance capital to a proactive state financing expenditures with borrowing.
Finally, because of the propaganda behind this blind fiscal conservatism, there is political opposition to increased public debt across the developed world leading to a withdrawal of stimulus measures and a turn to expenditure reduction rather than expansion. The result was not just slower growth. It was also the erosion of an instrument that since the Great Depression was seen as the main remedy for recession: enhanced public expenditure. Governments voluntarily gave up their right to resort to fiscal means to reverse the deceleration in growth, even in countries that were not recording large fiscal deficits and faced no threat of a public debt crisis. This not only directly affected growth in individual countries and across the globe. It also meant that countries that were dependent on exports to global markets to sustain much of their dynamism, whether it be Germany in Europe or China in Asia, are facing the danger of a slow down in growth. This is already visible in Germany, as noted above. It is likely to afflict China as well, especially if other countries choose to partially close their economic border in response to the crisis.
Governments now respond only when finance (not the real economy) is under threat. As happened in 2008, they are intervening today because of the threat to the banking system, which is quite heavily exposed to public debt, especially in Europe. But since fiscal conservatism has gripped most developed country governments and fiscal policy is not seen as an alternative, monetary policy or the infusion of liquidity into the system by having central banks purchase government bonds held by the banks has become the main tool to combat fragility. The European Central Bank that was adopting a conservative stance has gone shopping for government bonds including Greek paper to support the banks, while the US Federal Reserve has tied its hands by committing not to increase interest rates from their near zero per cent level in the foreseeable future. The latter would be fine if the global downturn keeps oil and commodity prices low. But if geopolitical and structural factors keep these prices, especially those of oil buoyant, the loss of the interest rate lever may necessitate further fiscal contraction and even lower growth as happened after the second oil shock of the late 1970s.
In sum, while the reliance on monetary easing may stave off a banking crisis for some time, the evidence increasingly shows it is likely to do little to stall the downturn in growth and trigger a recovery. If the downturn persists, confidence is likely to erode including confidence in government bonds.
There seem to be two messages coming out of the global economy right now. The first is that a second ”dip” or recession, potentially steeper than the first, is upon us and is likely to be of longer duration than the first. The danger this time around is greater because, for ideological and other reasons the fiscal weapon that governments had deployed in the first recession is now being abjured by them. On the other hand, there is no evidence of the emergence of alternatives that can serve as effective substitutes.
The second message is that after a long time the crisis that capitalism faces is centred on its metropolitan core and not the less developed periphery. Mere talk of decoupling cannot prevent this crisis from spreading to the export dependent economies in the successful periphery. The crisis it appears is bound to be global. Economically speaking capitalism is under siege. Its strength is that politically the attack on it is largely spontaneous, sporadic and fragmented. Till that consolidates and gains political momentum, chaos and anarchy seem to be the promise.