A consensus now exists that America's recession – already a year old – is likely to be long and deep, and that almost all countries will be affected. I always thought that the notion that what happened in America would be decoupled from the rest of the world was a myth. Events are showing that to be so.
Fortunately, America has, at last, a president with some understanding of the nature and severity of the problem, and who has committed himself to a strong stimulus program. This, together with concerted action by governments elsewhere, will mean that the downturn will be less severe than it otherwise would be.
The United States Federal Reserve, which helped create the problems through a combination of excessive liquidity and lax regulation, is trying to make amends – by flooding the economy with liquidity, a move that, at best, has merely prevented matters from being worse. It's not surprising that those who helped create the problems and didn't see the disaster coming have not done a masterly job in dealing with it. By now, the dynamics of the downturn are set, and things will get worse before they get better.
In some ways, the Fed resembles a drunk driver who, suddenly realizing that he is heading off the road starts careening from side to side. The response to the lack of liquidity is ever more liquidity. When the economy starts recovering, and banks start lending, will they be able to drain the liquidity smoothly out of the system? Will America face a bout of inflation? Or, more likely, in another moment of excess, will the Fed over-react, nipping the recovery in the bud? Given the unsteady hand exhibited so far, we cannot have much confidence in what awaits us.
Still, I am not sure that there is sufficient appreciation of some of the underlying problems facing the global economy, without which the current global recession is unlikely to give way to robust growth – no matter how good a job the Fed does.
For a long time, the US has played an important role in keeping the global economy going. America's profligacy – the fact that the world's richest country could not live within its means – was often criticized. But perhaps the world should be thankful, because without American profligacy, there would have been insufficient global aggregate demand. In the past, developing countries filled this role, running trade and fiscal deficits. But they paid a high price, and fiscal responsibility and conservative monetary policies are now the fashion.
Indeed, many developing countries, fearful of losing their economic sovereignty to the IMF – as occurred during the 1997 Asian financial crisis – accumulated hundreds of billions of dollars in reserves. Money put into reserves is income not spent.
Moreover, growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can't spend it all.
The world's unending appetite for oil, beyond its ability or willingness to produce, has contributed a third factor. Rising oil prices transferred money to oil-rich countries, again contributing to the flood of liquidity. Though oil prices have been dampened for now, a robust recovery could send them soaring again.
For a while, people spoke almost approvingly of the flood of liquidity. But this was just the flip side of what Keynes had worried about – insufficient global aggregate demand. The search for return contributed to the reckless leverage and risk taking that underlay this crisis.
America's government will, for a time, partly make up for the increasing savings of US consumers. But if America's consumers go from their near zero savings to a modest 4% or 5% of GDP, then the depressing effect on demand (in addition to that resulting from declines in investment, exports, and state and local government expenditures) will not be fully offset by even the largest government expenditure programs. In two years, governments, mindful of the huge increases in the debt burden resulting from the mega-bailouts and the mind-boggling deficits, will be under pressure to run primary surpluses (where government spending net of interest payments is less than revenues.)
A few years ago, there was worry about the risk of a disorderly unwinding of “global imbalances.” The current crisis can be viewed as part of that, but little is being done about the underlying problems that gave rise to these imbalances. We need not just temporary stimuli, but longer-term solutions. It is not as if there was a shortage of needs; it is only that those who might meet those needs have a shortage of funds.
First, we need to reverse the worrying trends of growing inequality. More progressive income taxation will also help stabilize the economy, through what economists call “automatic stabilizers.” It would also help if the advanced developed countries fulfilled their commitments to helping the world's poorest by increasing their foreign-aid budgets to 0.7% of GDP.
Second, the world needs enormous investments if it is to respond to the challenges of global warming. Transportation systems and living patterns must be changed dramatically.
Third, a global reserve system is needed. It makes little sense for the world's poorest countries to lend money to the richest at low interest rates. The system is unstable. The dollar reserve system is fraying, but is likely to be replaced with a dollar/euro or dollar/euro/yen system that is even more unstable. Annual emissions of a global reserve currency (what Keynes called Bancor, or the IMF calls SDRs) could help fuel global aggregate demand, and be used to promote development and address the problems of global warming.
This year will be bleak. The question we need to be asking now is, how can we enhance the likelihood that we will eventually emerge into a robust recovery?