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Mainstream, Vol XLVII, No 50, November 28, 2009

Brace Yourself, Crisis will Worsen!

Saturday 28 November 2009, by Bharat Jhunjhunwala


Leaders of the global economy are pleased these days. Chairman of the US Federal Reserve Bank Ben Bernanke sees ‘green shoots’ showing up on the economic landscape. Master investor Warren Buffet has claimed that ‘the financial panic is behind us’. I have doubts, though. It seems to me that it is instead likely that the world economy will slide into a yet bigger crisis in the coming two-to-three years.

Hope of recovery comes from the pick up in growth rate in the United States to a respectable 2.5 per cent this quarter. But this growth may be artificial. Robert Kuttner, co-editor of The American Prospect, writes:

Every major sector that reflects the purely private economy has been losing jobs, the only exception being energy extraction plus a tiny increase in computer systems design and management consulting. All of the other expanding sectors that are actually adding jobs reflect government spending-education, health, general government. But the declines in the workhorse parts of the private economy such as manufacturing, construction, and retailing are huge.

Remember that the US Government has increased spending to break the recession. This spending turns up as income in the national income calculations. The treatment of a patient in a government hospital adds to the GDP, for example. The much touted growth rate of 2.5 per cent is not built upon private business activity. This claim is like that of a person who has lost his job takes a loan to buy a television and declares he is ‘growing’.

In fact, this ‘growth’ is invitation to a deeper crisis. The US Government has issued Treasury Bonds to raise funds for increasing expenditures under the stimulus package. These expenditures are showing up as growth for the moment. But the Bonds will have to be redeemed soon. The US Government will have to raise money for this. But the expenditures are not leading to an increase in the private economy. In the result the tax collections are likely to remain flat. The government will have to impose more taxes on businesses to raise funds to redeem the Treasury Bonds. Businesses are already reeling from competition from cheap goods made by China and India. Additionally, they will have to pay higher taxes. This will add to the crisis.

The second sign of green shoots cited by Bernanke is increase in bank credit. Indeed this is a solid indicator of growth in normal times. But these times are not normal. They are exceptional. It seems the expansion of bank credit is deceptive. The Federal Reserve has lowered the interest rate to 0.25 per cent. This has opened up an opportunity for arbitrage. Banks can borrow money at 0.25 per cent and invest in one-year Treasury Bonds that give a return of 1.4 per cent. Some of the increase in bank credit is likely to come from this source. It is like oil floating on water without any connection with the real economy. Continuing job losses indicate that the real economy is floundering.

The third sign of hope is simply irresistible enthusiasm. Warren Buffet said in an interview:

The American economy will come back... Businesses will be formed. Businesses will expand... We’re not out of the hospital yet. But we will come out of the hospital... It happened in the 19th century, it happened in the 20th century at various times, and we’ve always come back stronger.

But history teaches that it teaches nothing. This is 21st century and the rules of the game have changed. Previously many technological innovations such as electricity, telephone, radio, steam engine, internal combustion engine, airplane and computer were taking place in the Western countries. The US economy has bounced back from previous crisis on the strength of such innovations. In 1997-98, for example, the US economy was down. The US had started to cut investment in Thailand and also on imports of cars from that country. This was the cause of the East Asian crisis of the late nineties. The internet was developed at this same time. Huge profits were made by companies like Microsoft and Cisco Systems. The NASDAQ was booming. These innovations in the IT sector pulled the US economy out of the slowdown.

I have doubts whether that experience is repeatable. Technological innovations appear to have reached a plateau these days. Moreover, new innovations may not take place in the Western countries. The cheapest car Nano, for example, has been made in India. Research is being increasingly outsourced. Thus the US economy may not bounce back this time as it has done in the past.


It is more likely that the Western countries will face the double problem of stagnation and inflation. The Central Banks have adopted easy money policy to make available funds to their governments for increasing expenditures under the stimulus packages. As mentioned above, the US Federal Reserve Bank has reduced interest rates to 0.25 per cent—the lowest possible. This is leading to more borrowing for buying Treasury Bonds and to an increase in money supply in the economy which, in turn, will lead to increase in prices. Surely, businesses have also benefited from the low interest rates. But their main problem is not interest burden. Their main problem is high domestic wage rates. An unskilled worker is paid about Rs 200 per day in India against Rs 3000 in the US. The reduction in interest burden is not big enough to compensate for the high wage rates. Thus the private economy is likely to remain subdued and tax revenues of the government will be down. But the government will have to redeem the bonds that have been issued to finance the stimulus package. The government will have to impose taxes to raise money for this redemption and push the private economy into deeper crisis.

The impact of this deepening of the global crisis on India will be mixed. Our share markets may face pressure. Foreign investors had withdrawn in 2008 when the banking crisis had struck in the US and led to the collapse of our share market. On the other hand, it is also possible that global investors may exit from the sinking US markets and buy in the rising Indian markets. The experience of the last six months indicates a return of foreign investors. The overall impact is, therefore, likely to remain mixed. Our exports will likewise face a mixed impact. Vendors supplying to US manufacturers will come under pressure as the US economy implodes. But we may be able to increase our exports to Africa and South America who may find our goods cheaper than those being supplied by the US till recently. Remember the main cause of the present crisis is that Western companies are unable to face competition from the cheap goods made in China and India. Therefore, the loss of Western countries should partly, at least, translate into a gain for us. Instead of hoping to redo business as usual with the revival of the Western economies, we should work out strategies to benefit from their impending collapse.

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