Economic aspirin: a palliative, not a cure

Will the government’s economic rescue package revive the economy, which is caught in the throes of a global recession? Alas, no.

The rescue effort is the equivalent of giving aspirin to a patient suffering from malaria. This may reduce the patient’s temperature and make him feel better than otherwise. But it will not end the fever, which will have to run its course. So, expect economic distress to continue for at least six months, maybe longer.

Global factors, originating in the US, have caused the recession. Unlike past downswings, the current one did not start with the weakest, smallest corporations dying first. The five biggest investment banks of Wall Street disappeared in smoke. The world’s biggest insurance company, AIG, went bust. The two biggest mortgage lenders, Fannie Mae and Freddie Mac, went belly up.

The world’s biggest bank, Citibank, looked like collapsing but was rescued by the US government.

So, since September, fear has swept across the world that even the biggest companies are endangered, and may not pay their bills. US financial markets froze in October. Nobody was willing to lend to even the most exalted borrowers. This fear whipsawed across the world, freezing markets everywhere, including India. Lenders became afraid to lend, borrowers afraid to borrow, and consumers afraid to buy.

Normally, booms and busts are transmitted from one country to another through trade and financial flows. For instance, a US recession might mean fewer imports, and less US investment abroad. But this time the transmission mechanism has been fear. The internet and TV have transmitted fear at lightning speed across the globe. Hence the collapse of car sales in the US in October was mirrored by immediate car sales collapses everywhere–in China, India, Russia, Latin America. The transmission mechanism was fear, not trade or finance.

We see a simultaneous recession in the US, Europe and Japan. Collapsing commodity prices will shrink all commodity-exporting economies. India’s GDP growth will slow to maybe 7% this financial year and 5-6% in 2009-10.

India’s exports have grown faster than GDP for years. But in October and November, exports have gone into reverse gear. Industrial production in October has fallen for the first time since 1993. Export industries claim that they will shed a million jobs.

To revive the economy, the government has announced a fiscal stimulus package of nearly Rs 30,000 by the end of the financial year, equal to Rs 120,000 crore in a full year. Over and above this, RBI measures since July have injected Rs 150,000 crore of liquidity into the economy by slashing lending rates and bank reserve requirements.

India is hardly alone in this. Countries across the world are announcing fiscal and monetary stimuli. China’s stimulus package is worth a whopping 4 trillion yuan over two years.

Even so, the world economy is slipping inexorably downhill. China’s export growth turned negative in November, so the engine of the world’s fastest-growing economy is sputtering. The US provided a fiscal stimulus of $140 b. over the last twelve months, followed by a financial rescue package of $ 700 b. The price of oil has plummeted, putting a lot of money into the pockets of vehicle owners.

Why, then, is the world economy still falling? Well, it enjoyed an unprecedented boom in 2003-2008, when world economic growth broke all records. India became a miracle economy, averaging 9% growth, Even Africa averaged 6%.

Alas, that boom was based on unsustainably huge trade deficits, unsustainably high borrowing by US households and corporations, and unsustainable speculation that drove up the prices of houses, stocks and commodities. Experts warned for at least two years that this unsustainable binge would end one day, and it did. That is the nature of the business cycle.

Readers ask, when will India’s economy recover? India is now deeply integrated with the global economy, and will revive only when the world economy does. In a globalised world, no single country can boom in isolation.

This was proved dramatically by France in the 1980-82 recession. President Mitterand did his level best to boost France at a time when the rest of Europe and the US were in deep recession. But all his stimulus efforts failed. France was too closely integrated with the world economy to boom when others were sinking.

The same holds true of India today. The government package is a palliative, not a cure. It will mitigate the pain until the global recovery begins. That will happen when fear is replaced by optimism, when markets unfreeze, when lenders begin lending and buyers begin buying the world over. That same global tide of optimism will wash into the Indian economy too.

What can trigger such global optimism? Nobody knows. But the slump began in the US housing market, so the recovery may start there too. One day, Americans will decide that house prices have fallen too far, and suddenly home buying will pick up. Once optimism replaces fear in the housing market, it could do so in the stock market, commodity markets, and the real economy. But I doubt this will happen till mid-2009, maybe later. The immediate future is grim.

What do you think?