A rapid recovery is unlikely
Financial Express, 12 May 2009
Many people are optimistic about a rapid recovery for the world economy. This seems to be an unlikely scenario. While financial markets respond quickly to news, and the worst of the financial crisis has indeed passed, there is an inevitably slow process of the downturn working its way through the real economy.
With a sharp recovery in many asset prices worldwide, there is renewed optimism about a rapid recovery. In the best of times, financial markets are forward looking and impound news well before the fact. Asset prices crashed well before the worst economic data came out, and asset prices will surely rise well before the economic data shows a robust recovery. An upsurge in asset prices can only, at best, presage an economic recovery some months or quarters away.
One area where there is hope is the end of the financial crisis. After the death of Lehman on 15 September 2008, for some time, there was fear that almost anything could happen. The money market in London, that wellspring of modern capitalism, had stopped working. All normal rules of how finance works were apparently suspended. Conversely, there were fears of governments over-reacting to the crisis. Large scale nationalisation could have come about; an Indian-style license-permit raj could have come about globally in finance.
These worst fears have ended. Normal rules of finance are increasingly coming back to characterise markets and transactions. Large scale nationalisation has been considered and rejected. There is no hint of the world regressing into an Indian-style license-permit raj in finance. The reform proposals in the US and the UK, and the thoughts of the G-20, are about identifying and solving the problems that gave this crisis; they do not envisage moving away from the enterprise of financial capitalism. These developments are indeed cause for cheer, and are worth a significant bounce in asset prices. Perhaps that is all there is to recent asset price gains.
Turning to the real economy, the picture is still bleak, and there are three ways of seeing this.
- In the US, there is a sharp decline in demand as households get back to saving and spend less on construction investment. The stimulus programs that have been announced do not measure up to the size of the problem. Exports from the US have been hampered by the strong dollar. Hence, there is little sign of a recovery in the US.
The outlook for policy activism in the US is also not that positive. The Obama administration needs to go back to Congress with three important blocks of legislation in the coming year: authorisation for bank recapitalisation, a fresh fiscal stimulus, and reforms to financial regulation. These efforts will face significant political constraints.
- The second issue is the mechanics of business cycle downturns. Some firms go bust; their workers lose jobs; these workers pull back on consumption; demand for other firms shrinks; other firms feel profitability go down and pull back on investment; this leads to more firms going bust, and so on. This process plays out over months and quarters, much unlike financial markets which absorb information within a day or two. This grim process is underway around us. Even if finance magically came back to its feet today, it would take time for the downturn to reverse itself.
Relative prices in the world economy have changed dramatically, driven by sharp changes in the prices of commodities, exchange rates, bonds, shares, etc. Global capitalism has to now solve out for an optimal structure of production that makes sense in the light of these new relative prices. While this will surely happen, large changes in the structure of production do not happen quickly.
- The third reason is derived from history. The NBER dating says that the US downturn began in December 2007. By the standards of the average post-war recession, it is about time for a recovery to commence. But this is not an average post-war recession. Recessions brought about by financial crises tend to be more troublesome, because it is hard for the economy to come back without the assistance of a strong financial system.
A key concern lies in the fact that what we have is an unprecedented synchronised downturn in the US, Japan, Eurozone and the UK. In other downturns (e.g. the East Asian Crisis), afflicted countries were able to pull themselves out of the dark times by latching on to exports demand from fast-growing parts of the world (assisted by big currency depreciations). This dimension is missing in this downturn.
Turning to the data, the S&P 500 index dropped from a recent peak value of 1561 (12 Oct 2007) to a recent bottom of 683 (6 March 2009). This was a decline of 56%. From there, a 32% recovery has come about, to a value of 903. This is still 42% off compared with the October 2007 level. This seems to be consistent with optimism about a recovery in finance but caution on business cycle conditions.
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