A GREAT RECESSION, NOT A GREAT DEPRESSION

GERARD LYONS
Dr Gerard Lyons is chief economist at Standard Chartered
June 22 - 28, 2009

This is not the Great Depression. But it has been called a Great Recession. It certainly is a deep crisis, the outcome of which will depend on the fundamentals, the policy response, and confidence. Here, I focus on the policy debate.

To understand what is happening, it may be helpful to view current events as part of the shift in the balance of power from the West to the East. This shift will take many years. But it is happening. And this not only has a bearing on the current recession, it also has huge implications for the type of recovery we are likely to see.

Two key factors contributed to this crisis. One was the imbalanced nature of the world economy. The other was systemic failure within the financial system. Fixing the two will not be straightforward and will take time.

Even though there is a need in the future for a more balanced global economy, the key now is demand. Boosting demand, even if it delays the move to a more balanced world economy, may be better than the alternative, which could be an ever-deepening downward spiral.

Equally, within the financial sector, it is vital to fix the parts that were broken, but not everything needs fixing. Many parts of the financial system worked well and, even in the parts that broke, there were well-run institutions that did not get into trouble. All of which suggests the need to differentiate, from both an economic and a financial-markets perspective, between the immediate outlook and the longer-term issues.

The G20 London summit was an important step towards finding a global solution. Gordon Brown, Barack Obama, and Hu Jintao were instrumental to its success. Some in Asia have even referred to it as the G2.5 Summit, with the focus on China and the US, and the UK seen as good hosts! The Chinese were proactive in the run-up to the summit, reflecting their desire to share ñ and to be seen to be sharing - the common agenda of mending the economic and financial failures.

The all-inclusive nature of this meeting was welcome given the synchronised nature of the downturn. The very fact that this gathering was held was in itself a sign of how things are changing. There has been a growing need for global policy fora to give a greater weight to emerging economies.

The need to restore lending has been an ongoing issue throughout this crisis, and the collapse in trade since last autumn has been alarming. Thus, perhaps the most welcome aspect was the commitment by the G20 to ìensure availability of at least $250 billion over the next two years to support trade financeî by export credit and investment agencies and the multilateral development banks.

Of the other measures outlined, additional money for the IMF was a big plus, particularly as it will help the Fund to respond as the crisis hits harder. A commitment to future reform of the Fund was also implicit in the G20 statements. Again, this is a long-overdue positive and furthers a sign of the shift in the balance of power.

The new Financial Stability Board, announced by the G20 as the successor to the Financial Stability Forum, had its membership extended to include all G20 countries and its mandate broadened to promote financial stability. The net effect will be to give greater weight to emerging countries in overseeing the financial sector.

It is worth stressing that as welcome as these new initiatives from the G20 are, they are unlikely to be able to stop the recession quickly. But they should, along with measures already taken and still more yet to be taken, be able to limit the downside and shorten the downturn.

In that sense, the London Summit should be seen as work in progress. It follows a host of other policy measures which are yet to feed through fully. When one looks across countries, the policy measures unveiled so far in this crisis effectively fall into four distant categories: (1) support to the financial sector, including liquidity provision, funding guarantees, capital injection, and removing impaired assets from bank books, (2) exchange rate policy, (3) fiscal policy, and (4) monetary policy. Here I will focus on the last two, fiscal and monetary policy.

FISCAL POLICY

Under current conditions, fiscal policy should be very effective. If people and firms are not spending, it makes sense for governments to step in and spend. But even allowing for this, a combined policy boost using fiscal and monetary policy may not be able to prevent the recession. Instead, it is more likely to be successful in limiting the downside and shortening it.

The more open a country is, the higher the likelihood is that the effect of any fiscal boost will leak overseas. Thus, it is far better if there is a coordinated global fiscal boost, as the US and UK had been hoping for.

Chinaís relatively closed economy, meanwhile, improves the likely effectiveness of its huge planned stimulus.

Government spending is more effective than tax cuts in the near term. And, the more directly the government spends, the greater the likely impact.

Some countries, like China, Singapore, and Chile, have relaxed fiscal policy aggressively, but their initial budget situations were sound. In contrast, the UK and the US had poor initial positions and the scale of their easing has added to market worries.

Indeed, the fiscal boosts in Korea and the US are amongst the largest of the OECD member countries.

Meanwhile, China, not an OECD member, has a huge stimulus package, and it was reported that after the London Summit that President Hu hinted that another would be forthcoming if needed.

Across much of Asia, the fiscal response has been sizeable and speedy. While in many countries it is not a panacea for the collapse in external demand, it has tried to address weaker demand while seeking to maintain social order and the health of the financial system and to enhance long-term competitiveness.

MONETARY POLICY

What about monetary policy? Central banks, by and large, have responded well since last autumnís stage of the crisis. There has been substantial policy easing around the world.

Across Asia, central banks have also responded with significant easing. Since September, for instance, policy rates have fallen by 216 basis points (bps) to 5.31 per cent in China, by 150bps to 4.50 per cent in the Philippines, by 150bps to 2 per cent in Malaysia, by 200bps to 7.50 per cent in Indonesia, by 250bps to 1.25 per cent in Thailand, by 700bps to 7.0 per cent in Vietnam, and by 275bps to 3.25 per cent in India. In addition, reserve requirements have been cut in India, China, and Malaysia. With inflation pressures subdued and growth weak, further rate cuts are likely across the board in Asia.

There is discomfort in the markets about the actions of the central banks, with some fearing that actions currently being taken, or that might be taken in the future, will trigger inflation. These concerns should certainly not be dismissed, but they also need to be kept in context. In the absence of an economic recovery, and with so much spare capacity (or large output gaps) across economies, it is questionable whether central banks can generate inflation at this stage of the cycle.

Because of this, inflation expectations are still relatively subdued, despite the aggressive monetary easing currently taking place. In the West, deflation strikes me as a bigger risk than inflation. And judging from recent Federal Reserve Open Market Committee minutes from the US Fed, this is where they see the risks.

This does not mean that there will be deflation - monetary easing will probably prevent it. And just as there is a need for fiscal policy to return to a sustainable level once the economy recovers, there is also a need for monetary policy to return to neutral, although that is some way off.

In both the US and UK, the central banks feel that they have the ability to exit, with a new financing programme in the US to issue new Treasury securities and drain excess reserves, and the Bank of England sucking out excess liquidity by selling assets it has bought or by issuing new bank bills.

Across the emerging world, inflation risk needs to be assessed on a case-by-case basis, although in many countries it is not an immediate problem. Once there is a recovery, the reaction of commodity and energy prices will have an important bearing, as it did last year - and that may be the channel through which inflation appears.

Overall, in terms of the policy response, it has been impressive, but there is further to go. Across Asia, there is scope for further monetary and fiscal easing, whilst in the West, further fiscal stimulus cannot be ruled out, though the focus may be on unconventional monetary policy.

(TO BE CONTINUED)