• PAGE ONE
• INDEX
• HOME

Countering global economic slowdown

Vivek Uniyal

FALTERING growth in the US, Japan and the OECD nations and the spectre of recession have triggered speculation on or whether or not the trough is in sight. Since markets are attuned to business cycles, fluctuations in income, employment, investment and p rices are inevitable. As a matter of eventuality, what counts is the rate of decline in various economic activities -- a fast rate could precipitate a crisis much before the actual bottom is reached. Worldover, financial circles are beginning to feel tha t the boom and bust cycles are rather antiquated.

There is plenty to worry about on the inflation front. In the services sector, price pressure is clear. So, the risks of over-correction or a hard landing are high. Short-term interest rates may reach 7.5 per cent in 2001 and it is reckoned that the econ omy will grow by only one per cent in 2002. It may not technically constitute a recession, but would be perceived as one. As deceleration in the global economy combines with a destabilising jolt, as it may happen with an earnings or dollar shock, the sli de may accelerate.

In the wake of the global economic slowdown, Asia's developing economies are facing a crunch. Over the last three months, the Thai baht's value dipped 3.6 per cent, the Korean won by 12 per cent and the Indonesian rupiah 9.7 per cent -- trading at 1,180 to a dollar. The yen fell 12 per cent in 2000 and another five per cent this year.

The UN Economic and Social Commission for Asia and the Pacific (ESCAP) said in its annual survey that the slowing world economy would reduce growth in Asia by 1-2 percentage points this year compared with 2000. South-West Asia is forecast to grow 5.8 per cent in 2001, while South-East Asia will grow 4-4.5 per cent and East and North Asia 5.6-6.4 per cent. The ESCAP survey says: ``Growth will certainly slow down on account of slower demand for exports.'' Asian economies, particularly Indonesia, the Phili ppines and Thailand, are still struggling to recover from the financial crisis that hit the region in 1997. Governments have become wary of excessive public spending; debt levels are on the rise. The ESCAP report urges the countries to streamline and rat ionalise public spending to avoid the debt trap wherein debt servicing obligations rise faster than revenues.

But will rationalised spending rise? If not public spending, then what about private investment spending? Given the low rates of savings in the developed countries, if consumers become nervous about their jobs and future predicaments, demand could drop s harply and aggregate spending could halt. In the recent slowdown, private investment has been decelerating. With profits dwindling, companies are resorting to lay-offs to survive. With no stimulus in sight, investment spendings are drying up and hastenin g the deceleration.

Earnings reported or profit forecasts by manufacturers have also been shrinking. Banks and airlines are also joining the ranks. Yesteryear success stories, Intel, Texas Instruments, Ericsson and Philips, are desperate for a whiff of fresh air. Old allian ces have snapped, with Ford and Firestone leading the fray. In a blow for Yahoo!, the American Internet portal, Mary Meeker, doyenne of dotcom analysts, opined that sales revenues in the next 12 months would fall below earlier estimates, blaming the `tou gh and wacky' world of online advertising for this. The Yahoo! share value has dropped 15 per cent. Even with free cash and Internet hype, markets could not expand beyond a point. And the market slowdown in the US and Japan will spill over into other mar kets, the first casualty of which will be exports, and pull down GNP in other countries.

The worldwide recession of the 1980s made it hard for LDCs to earn foreign currency by exporting goods to the industrial countries, and their markets contracted. Second, real interest rates rose dramatically making interest payments on debt harder to bea r.

Third, the dollar's value rose, making their international debts -- denominated in dollars -- onerous. The international value of the dollar soared in the early 1980s to 1985. The dollar's appreciation encouraged American imports, damaged its exports, an d has been a drag on aggregate demand. In real 1982 dollars, American imports soared 52 per cent in 1981-87, while American exports declined 4 per cent or $49 billion. A net export surplus turned into a deficit of $146 billion. Consequently, the GNP grow th rate turned out to be mediocre.

In view of the strong dollar, net exports fell and the aggregate demand curve shifted inward. At the same time, foreign goods became cheaper and the aggregate supply curve shifted outward. The price level in this interaction will fall. Output will also f all if the demand shift is more important than that of supply, as is likely.

After undergoing a terrible recession in 1981-83, the US economy bounced back and grew strongly for about a year-and-a-half. Thus, the output growth initially sagged and then spurted. In broadest terms, the Reagan administration engineered a turnaround i n the policy-mix towards tighter money and easier fiscal policy. The Fed's tight monetary policy was already in place when Mr Ronald Reagan was elected President. The new administration simply encouraged the Fed to persevere. The expansionary fiscal poli cy was mainly the result of the tax cuts of 1981-1984, leading to large and persistent federal budget deficits.

Loosening money supply through interest rate cuts should lower real interest rates, make the dollar depreciate, increase real GNP and bring in inflation. (A strong dollar makes it more inflation-prone.) The effects on output and inflation are uncertain - - depending on how monetary expansion, contemplated through interest rates, react to the government's fiscal stance. Rate cuts will provide a cushion for the downturn, but the timing problem remains. The main impact of interest rate changes usually take 9-12 months to boost demand. It may be too late for cuts in interest rates -- let alone the President, Mr George W. Bush's planned cuts in tax rates -- to prevent recession. If it is not a full-blown recession, it will be a prolonged period of sluggish g rowth.

In the short-run, the Fed may do better targetting of interest rates. But such a policy could, over long periods, land the economy in trouble. Money supply, in any case, works with a lag and increases in the money stock will eventually yoke the economy t o inflation. To avoid inflation in the long run is to keep money growth moderate and restore portfolio imbalances (disequilibrium). Moderate monetary growth should keep up with the demand for real money balances, keeping inflation at bay.

This theoretical underpinning accords well with facts. To revert to an estimate of the real interest rate on long-term US government bonds from 1978 to 1987, it rose sharply and astonishingly between the time of the 1980 election campaign and the time Re agan economic programme was enacted into law by September 1981. It then fell during the 1982 recession but rose again to very high levels in 1985. The historic norm is 2-3 per cent. To appraise the effects of Reaganomics on real output, a longer time per iod must be considered. If the full five-year period from 1981 to 1986 is taken, the average annual real GNP growth was 2.7 per cent. Since this precisely matched the average growth rate achieved in the preceding 15 years, the conclusion would be that mo netary contraction cancelled out the demand-increasing effects of fiscal expansion, leaving no net effect on the growth of aggregate demand.

The rising dollar certainly helped slow inflation in the early 1980s. Oil prices dropped. In addition, the fact that the deep recession came early in Mr Reagan's term of office meant that the economy had a recessionary gap throughout 1981-86. Since the R eagan tax cuts led to a large budget deficit, the US could have avoided a large trade deficit only by saving more or investing less. The latter is not a very sound option and, in any case, generous business tax cuts in 1981 shielded investment spending f rom the ravages of high real interest rates.

Interest rates have generally been falling since 1984 and the money supply has been growing rapidly. In the face of a strong dollar, the Fed has been resorting to aggressive interest rate cuts. A loose money policy and an expansionary fiscal policy amoun t to undoing the Reagan's policy-mix of tight money and loose budgets. According to many economists, what is now needed is the reverse: A monetary expansion coupled with a fiscal contraction. The latter course seems to be out of fashion. Tax-refund chequ es of $200-600 have already been mailed to taxpayers.Perhaps credit is a better target than either money stock or interest rates because individuals who want to spend do not necessarily have to have money at hand, but can instead borrow to finance their spending. Investment spending, in particular, is likely to be financed by borrowing, that is, by credit, and spending for investing is the key to business cycles. Thus, maintaining control over credit means controlling the investment rate and maintaining economic stability. Research suggests that a large part of the decline in output in the Great Depression (1930s) was the result of the breakdown of the financial system and the associated collapse in the quantity of credit, rather than the decline in th e quantity of money. The view that credit is a better target than interest rates results from the phenomenon of credit rationing. Credit is rationed because lenders fear that borrowers willing to borrow may not be able to repay.

It follows that the Fed can easily miscalculate and make economic performance worse rather than better when it tries to stabilise the economy. The Fed may have overreacted since the last year when it cut rates aggressively. The analogy is of a driver who heads towards a ditch, swings sharply to avoid the ditch, buts ends up in the ditch anyway.

(The author is professor of economics and business policy, Institute of Management Studies, Roorkee.)