[OPE] Mohamed Ariff explains why the recession will last longer

Mohamed Ariff, Why the current global economic crisis will likely last longer than usual (www.voxeu.org 28 January 2009).(...) Put another way, the policymakers are running out of ammunitions to fight the crisis.

The three main tools used during economic meltdowns are monetary, fiscal and exchange rate instruments, to stimulate a faltering economy.

- In the monetary policy domain, the central bank would reduce interest rates and relax statutory reserve requirements so that banks can lend more, resulting in increased consumer spending and investment expenditure which would augment economic growth.
- In the fiscal realm, the treasury would reduce taxes and increase public expenditure at the risk of budget deficits, not only to increase the disposable income of the people so that they will spend more, but also to pump-prime the economy through increased government expenditure that would take up the private sector slack.
- An appropriate foreign exchange rate policy under such circumstances would be to opt for a weaker currency, aimed primarily at external demand, as this would render exports competitive and divert domestic demand away from imports to local substitutes.

Unfortunately, the reality on the ground now in most countries, especially the US, is that all three instruments are somewhat blunt if not impotent.

- Interest rates are already at low levels close to zero in Japan and the US, while in many other countries they hover at historically low levels. Interest rate cuts would work well, only if interest rates are high to begin with and the rate cuts are substantial. Given the near-zero interest rates, further rate cuts can only be marginal with little impact, for nominal interest rates cannot fall below zero. In the US, real interest rates are negative, given the higher rate of inflation relative to nominal interest rate. In a recessionary setting, inflation tends to give way to deflation, with falling prices, in which case the interest rate would rise in real terms by becoming less negative than previously, thereby raising the cost of borrowing. In other words, the end result will be the opposite of what monetary easing is supposed to accomplish.

- The picture is quite similar for the fiscal instrument as well. Many countries, including Japan, India, Malaysia and the US, have been running large budget deficits even in good times year after year. Increased budget deficit through tax reduction and/or expenditure hike, in such cases, may only have limited impact due to fiscal fatigue. A budget deficit of, say, 5 per cent of GDP would have significant impact for an economy starting with balanced budget, but not for an economy already saddled with a deficit of 4 per cent of GDP.

- Where monetary and fiscal measures do not work well, the foreign exchange rate mechanism can help, if there were no constraints on exchange rate changes. Thus, an exchange rate devaluation or depreciation would increase demand for a country's products both at home and abroad by making exports cheaper and imports dearer. In theory, a country's currency would depreciate in the wake of an economic slump, but this is not the case with the US dollar, which has been strengthening in recent times defying gravity. The dollar could stay strong, despite US economic woes, thanks mainly to massive capital inflows into the US, as the US continues to borrow, and others wanting to keep the dollar strong so that they can continue to export to the US and at the same time protect their reserves from a possible collapse of the greenback. No way can the US economy recover rapidly so long as its currency remains unrealistically strong. The dollar will have to depreciate significantly for the US to produce more for exports and to divert its insatiable demand toward American products. Thus, exchange rate corrections are needed, not only to reduce the US current account deficits but also to stimulate domestic production for both external and internal consumption. This, however, is unlikely to happen anytime soon, given the global addiction to the greenback, and hence the failure of the exchange rate instrument.

With all three major policy tools, namely monetary, fiscal and exchange rate, reeling under heavy sedation, the chances of a quick recovery are quite slim. The writings on the wall thus suggest that the crisis will stick around for at least two years, if not longer. http://www.voxeu.org/index.php?q=node/2910

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Received on Thu Jan 29 19:19:29 2009