Recovering from Crisis: Dealing with a second dip

C.P. Chandrasekhar

August 2010 brings news on global growth which is disconcerting to say the least. Numbers from countries across the globe suggest that the incipient recovery characterising the world economy may already be losing steam. The US economy recorded a lower 2.4 per cent growth in GDP in the second quarter of this year compared to a much more comforting 3.7 per cent in the first quarter. This news followed the evidence that industrial production in Japan fell by 1.5 per cent in May. And finally, an (unusual) index of demand growth in China, which is being looked to as the driver of global growth, shows that demand is stabilising. The purchasing managers’ index (PMI) published by the China Federation of Logistics and Purchasing slipped from 52.1 in June to 51.2 in July, closer to the 50 point level that signals positive growth.

These changes may not be substantial or even indicators of a medium term shift in growth trends. But with the world sitting on worries of a potential second dip, they are receiving attention. The search for instruments to drive the recovery is still on. Yet the pressure to curtail public spending and reduce public debt is strong in most contexts. This leaves monetary policy as the alternative to generate a recovery.

But clearly fiscal and monetary levers are not on par when used to drive growth or reduce absorption. This is an issue that is forgotten when conservative reaction against deficit spending and public debt decries a proactive fiscal policy and defends retrenchment even when growth is slowing. Consider for example the reduction of growth in some contexts because of a decline in credit provision and/or credit off-take. It must be noted that this squeeze on credit flows is not so much the effect of central bank initiatives in the form of, say, increased reserve requirements. In a complex financial world with multiple markets, institutions and instruments, monetary policy is rarely too effective in influencing anything but the interest rate.

Credit flow is influenced more by the state of confidence. If banks and other financial institutions are more risk sensitive because of economic and financial conditions and borrowers are worried about taking on additional debt because of accumulated commitments and uncertain earnings prospects, the provision and off-take of credit shrinks irrespective of government policy. It is only when the government or central bank is in a position to directly influence banking behaviour that fear of “overheating” can generate responses that constrict credit flows further.

It is well accepted that it is the loss of confidence and the legacy of negative household balance sheets that is holding back credit flow and consumer spending in the US, for example. This suggests that triggering recovery requires relying more on a fiscal stimulus rather than monetary policy initiatives. Restoring confidence and repairing household balance sheets would prove impossible if the US government were to cut back on its stimulus. It is perhaps the waning of the fiscal stimulus and evidence that the push to curtail it is gaining momentum that could explain the facts that growth is once again flagging in the US.

In fact countries which relied heavily on credit to stimulate their economies are facing new problems. In China, for example, the government is worried about the fact that excessive reliance on lending as part of the stimulus package adopted in the wake of the global crisis has encouraged speculation. Real estate prices have skyrocketed and even insiders have reported banks are burdened with loans of poor quality given to local governments to finance infrastructure projects. A review has identified about Rmb1,550 billion of such loans on bank balance sheets. Not surprisingly China’s banks (including Agricultural Bank of China and ICBC) are rushing to market to raise funds to shore up their capital base. In the event, the government has chosen to intervene directly to rein in  such credit to both dampen speculation and hold back errant banking practices.

There seems to be a message here. If intervention to sustain recovery is seen as warranted, it is fiscal policy that must take the lead. This is also true because, if the will is there, governments can tax to reduce deficits and rein in debt. Households and firms cannot do that and must wait for growth or a government bailout.

3 Responses to “Recovering from Crisis: Dealing with a second dip”

  1. This very accurate and well written paper is a perfect sociological example of how thoroughly modern thought avoids admitting ever more rapid economic growth is the cause environmental collapse that is generating the environmental friction that makes further growth ever more difficult. Former economic growth was clearly based on appropriation of Mother Earth’s free lunch into the corporate structures of Nation States which function to support corporatist rights to the free lunch, at the expense of human health, rights and liberty.

    It is impossible to grow faster and faster to infinity upon a finite planet. Therefor as population peaks and begins a gradual decline accompanied by declining planetary resources and pollution disposal services – less free lunch for appropriators and their client governments – economic theory is faced with discussing reality; permanently declining quantitative production, and systems to increase qualitative growth that does nothing except increase human well being and environmental health.

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