Is this going to be a long recession?

There is much talk of green shoots heralding the end of the global recession. Stock markets are shooting up globally.

But the International Monetary Fund (IMF) has just issued its gloomiest forecast ever. It says world GDP, which has never shrunk since the Great Depression, will shrink 1.3% in 2009, and then inch up to 1.9% in 2010. Growth of less than 2% indicates a global recession. So, serious recovery will not come before 2011.

The government predicts a rapid recovery in the second half of this fiscal year. The RBI projects 6.5% growth in 2009-10. But the IMF’s projection for India is just 4.8%. Maybe the IMF will revise its projections upwards. Yet, we must ask, why is the IMF so downbeat?

Indian economists focus largely on the Indian scene, while the IMF focuses on the dismal world economy. History shows that recessions accompanied by a financial crisis are deep and long. India has no financial crisis, and so Indians are complacent. But the world has a gigantic financial crisis.

The IMF sees world growth being strangled by what it calls negative feedback loops. The financial crisis first reduces cash flow to producing sectors. This causes a recession, with producing sectors slashing production and employment. But the recession then makes the financial crisis worse — more corporations and individuals default on bank loans. The banks respond by cutting credit further, and this hits production and employment further. This is the negative feedback loop.

The IMF now estimates that lending institutions globally may eventually have to write down a staggering $4 trillion of bad debts, four times India’s GDP! The US is worst off, having to write down $2.7 trillion. But Europe also has to write down $1.2 trillion, and Japan $149 billion. Faced with this red ink, some of the biggest global banks are technically bust. They need to raise huge sums of fresh capital, enough to write off their bad debts and start lending again. But who will supply so much? Certainly not private investors, who have already lost a fortune. So governments globally have mounted a massive rescue effort. In the US, public-private partnerships are also being tried to provide fresh billions.

Banks have lent too much in relation to their own tangible capital. To move to the point where their loans come down to 16.5 times their tangible equity — a conservative target — US banks have to raise an additional $500 billion, European banks $950 billion, and British banks $250 billion of equity. These are staggeringly large sums, considering how much rescue money has already been dished out.

Yet, until the financial sector is made solvent again, it will not restart lending fast enough to kickstart the world economy. The world needs to go from negative to positive feedback loops. For that, banks must lend much more to productive sectors, which will then raise production and employment, which will then boost bank profits and encourage further lending. That’s how the current vicious cycle can give way to a virtuous one.

Apart from equity, governments have so far provided a massive $8.9 trillion to banks through lines of credit, asset purchase schemes and guarantees. You might think that’s more than enough. But the IMF estimates that this is less than one-third of their needs. Bank deposits will grow with GDP, of course, providing them with some cash for lending. But the banks also need sums for repaying their old obligations. The refinancing gap of banks, the IMF estimates, will rise from $20.7 trillion in late 2008 to $25.6 trillion in 2011. The danger is that they will meet this by slashing future lending.

The sums needed for rekindling the world financial sector are frighteningly large. But the US and European public is already rebelling against providing more taxpayer money to rescue bankers, who are reviled as crooks and thieves. The culpability of the bankers is beyond question, but they have also suffered: the billions they got in stock options have become largely worthless with the stock market crash. However, if the public refuses to allow governments to pour additional hundreds of billions into rescues, then the global financial system may be starved of essential capital. And if so, the negative feedback loops will continue, and the recession too.

Now, some economists like Michael Mussa disagree strongly with the IMF. They give historical examples of economies recovering despite little or no recovery in bank credit. Once confidence soars, that alone can spark fresh production and credit, a virtuous cycle. Optimists like Mussa and Surjit Bhalla predict a V-shaped recovery. I myself tend towards pessimism. Let’s hope for the best, but prepare for the worst.

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