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Recession: No end in sight
January 17, 2009
The annual Neemrana conferences on the Indian economy provide a valuable opportunity to take stock of the state of the US and world economies, and the implications of global developments for the Indian economy.
The conferences are held annually at the Neemrana Fort Palace hotel in Rajasthan. They are co-hosted by NCAER and the Indian Council for Research in International Economic Relations.
International (primarily US) participation is organised by the National Bureau of Economic Research, arguably America's most respected network of academics engaged in empirical research on issues of economic policy. The format is designed to encourage informal, off-the-record discussion on a range of current issues of economic policy.
This year marked the tenth delivery of the conference, against one of the most challenging environments for the global economy.
Despite the roaring boom of the past few years, past conferences had repeatedly warned of the unsustainability of two structural trends, namely the size of the US current account deficit and the decline in the US household savings rate that lay behind it.
However, the depth of the crisis in the US financial system and economy, and its global impact was difficult to anticipate even as recently as a year ago.
Prior to the conference, my somewhat unthought assumption was that the worst was probably behind us as far as the slowdown in the major economies was concerned.
The discussion at the conference, particularly with regard to the US and European economies, suggested that this was no more than wishful thinking, and that considerable pain lies ahead.
(There was relatively little discussion of the prospects for the Japanese and Chinese economies; these are unlikely to improve the picture, however.)
Quite apart from the overall assessment of the short-term outlook, however, was the nature of the analysis that led to these sombre conclusions, and which I would briefly like to address. In the case of the US, the underlying mechanism at work is a massive re-pricing of risk by financial institutions following the unexpectedly high default rates on sub-prime mortgages that began to be evident some two years ago.
This repricing of risk has led to the destruction of household financial wealth in the two principal assets held by American households, namely residential real estate and equities; between these two, the estimated reduction in household wealth is of the order of $10 trillion.
Historical estimates suggest that this would lead households to cut back their consumption by around 4 per cent of their reduced wealth (just as the past enhancement of this wealth led to major increases in consumption in the boom).
This estimated cutback in consumption alone represents a negative 'demand shock' of approximately 2.5 per cent of US GDP, or $400 billion.
Added to this withdrawal of demand is the slowdown in housing construction: a million fewer housing starts represents a further withdrawal of around $200 billion in demand. So the 'demand gap' that needs to be filled just to replace these two sources is of the order of $600 billion on an annual basis.
This is without taking into account other destruction from demand either in terms of (net) exports or reduced corporate investment, both of which are likely under present conditions.
The only silver lining is the relief household budgets will receive as a result of lower fuel prices. (This was not quantified.)
Under normal circumstances, both monetary and fiscal policy would be available to offset such sharp "autonomous" decreases in final demand.
Unfortunately, despite Herculean efforts by the Federal Reserve, monetary policy is not generating any traction because of the seizure in the credit markets, itself largely related to uncertainties on the valuation of housing-related securities.
No effective floor has so far been placed under house prices, despite several proposals to do so.
The impact of house price declines on the balance sheets of financial institutions is enhanced in the case of the US by the fact that, in most states (and unlike the situation in other advanced countries), mortgage loans are 'non-recourse'.
That is to say, they are only secured by the value of the house, and are not secured by other assets of the borrower. Approximately 25 per cent of all houses with mortgages are now worth less than the value of the mortgage that they bear, encouraging homeowners to surrender their homes and walk away from the loan.
This additional supply further depresses prices. So there is no immediate reason to see a return to normalcy in US credit markets, not at least until a floor is found, or is placed, under housing and equity markets.
The past and likely future inefficacy of monetary policy therefore puts all the burden for replacing the 'missing demand' on fiscal policy.
Yet the prospective design of the Obama fiscal stimulus package came in for criticism both as to scale and as to composition. If the advertised figure of $775 billion over two years is accurate, then on an annual basis the injection of demand is only half as large as is needed.
However, to the extent that a portion of the relief is in the form of temporary cuts in income taxes, recent evidence suggests that such cuts tend to be saved rather than spent, particularly in an environment where households are busy rebuilding their balance sheets.
If the demand 'hole' is not adequately plugged, then second-round multiplier effects could worsen the downturn.
The US remains central to the global recovery, which is why I have covered it in such depth. The story from Europe is gloomy for many of the same reasons but for two additional ones.
Several of the smaller countries have very high levels of debt already and are likely to be penalised by the markets for expansionary fiscal policy. Second, members of the Eurozone lack the instrument of exchange rate adjustment.
There is the additional factor that the leading European economy, Germany, which does have fiscal space, is unconvinced of the efficacy of fiscal stimulus.
Finally, G-20 protestations to the contrary, there was considerable expectation that protectionist tendencies are likely to intensify in this global climate.
All it is an all an ugly environment for India to face as it struggles with its own issues of internal security, corporate governance and general elections.
Welcome to 2009!
The author is director-general of the National Council of Applied Economic Research. Views expressed are personal.
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