Does anyone have a post-recession exit strategy?

by Percy Mistry.

[for the Financial Express, November 27th, 2008]

The past was prologue. The present is panic. The future: a conundrum? Banks in every country, along with their industry counterparts, are queuing up for liquidity, capital, or guarantee assistance. "If him, why not me?" Such 'me-too-ism' has triggered a cascade of knee-jerk reactions in governments around the world. The US has a bailout a day. The UK and EU follow a day later. The two giants of the future, India and China, are in on the act. The trend is snowballing downhill and we now have a recession.

Fiscal/monetary expansion in Sep-Oct, 2008 was aimed at averting financial system collapse. In November, it was redirected at preventing global demand collapse. Extolling the lessons of 1929-39, when the global economy was rescued (paradoxically) by a world war, governments seem willing do anything; no matter how unacceptable in 'normal' times (what were those like?) to avert deep, prolonged recession, even a growth recession. Politically and socially, its consequences are unthinkable; especially for administrations (like India's) at a critical juncture in their electoral cycles.

With gargantuan amounts of cash being pumped out, is there a risk of the world later drowning in a flood of worthless money created by well-intentioned public recession-fighters? Will such profligate largesse defer, or prevent from taking place, the adjustments needed to rectify chronic global imbalances in consumption, savings, investment, and borrowing? Policy-makers might regard such questions as misplaced, churlish, or premature. To them, any voice asking right now whether they know what they are doing or overdoing, is a foolish intrusion that will make this recession and financial crisis worse.

Keynes' solution of expanding countercyclical fiscal deficits to combat declines in output had a caveat; that, in boom times, governments must generate fiscal surpluses. Since 2000, most governments have been running large deficits in booms; not least in India. They now want to run even larger deficits to mitigate a bust. The logic seems to be that, since irresponsible government spending and borrowing created this mess in the first place, more reckless government spending and borrowing will get us out of it. Such reasoning may seem sensible to economists armed with theory. It is difficult to explicate to laymen armed only with common sense. That may be why economists are held in the regard they are. If experts think that unrestrained money-pumping will work out in the short and long term, they need to explain why. Perhaps we should be concerned that the experience of 1929-39 taught us what NOT to do in a recession; i.e. tighten the fisc and squeeze money supply. Unfortunately, it did not teach us WHAT to do, or be sure that what we are doing (i.e. the opposite of what was done before) is right. There is no play for this unprecedented scenario that has been rehearsed and worked out.

Looking to governments to solve the problem has dispensed with all concern about privatising profit and socialising cost. Diehard socialists and pompous purveyors of bizarre heterodoxy (suspicious of markets they cannot control directly) are gloating yet distraught. If we probe deep enough, looking to governments to solve the present crisis is not as odd as it seems. Our current predicament is rooted in: (a) prolonged, cavalier irresponsibility of governments - i.e. in irresponsible management of fiscal, monetary, trade, and external accounts (on the part of the US, UK and EU sans Germany), and (b) in self-serving, but globally damaging, exchange rate policies from 2000 to now on the part of China and, a lesser extent, India. The 2008 debacle is not, as populists would have it, rooted exclusively in financial system failure, with excess leverage and risk exacerbated by absurd compensation incentives that skewed the judgement and ethics of the financial community; though there was certainly plenty of that.

Winning the short-term battle of boosting demand and corporate cashflow now seems to be all that matters to former titans of finance and industry. Crisis-induced collapse of demand provides them with a timely excuse to obscure errors of vision, judgement, timing, strategy, and business-model failure. In making billions they believed they were omniscient, omnipotent, invincible, and infallible. Faced with losing billions they want society to bear the cost of their failures. That is the Faustian bargain of mutual assured destruction (MAD) that corporates, governments and consumers have made. So, the notion of taxpayer bailouts of banks and companies may be a tautological nonsense. In the final analysis, the taxpayer (or government on her behalf) is bailing out not banks and firms but herself - in her other avatars as consumer, borrower, depositor, businesswoman, employee, supplier, and producer.

The possibility that victory in the short-term battle of reviving cashflow might result in losing the long-term war of financial responsibility and equilibrium, seems not to matter. To comfort the public that they will do everything in their power to avert prolonged recession, governments are acting in ways that we may not realise the consequences of. The US' serial bailouts have enlarged its fiscal deficit by over 10% of US-GDP. We have not seen the end of them. Adding the UK and EU you get another 8-10% of their GDP. Add others and you have incremental fiscal deficits and incremental net public borrowing piling up to over $5 trillion in the next 1-2 years. This will all need to be borrowed from central banks (risking future inflation) or capital markets where savings are overstretched.

A dramatic shift in risk preference now favours bank deposits and government bonds. But, what happens when that preference shifts to other investments, as it eventually must? Will the shift of all incremental savings into US/EU government debt create stickiness for the eventual recovery of equity markets thereafter? By then the US will owe the rest of the world US$7-8 trillion. What does it mean when the only large reserve currency issuer is the world's largest debtor, sucking in capital from countries that need it more for their own development? Should the world's reserve currency issuer and largest debtor remain exempt from multilateral control, surveillance and guidance when it continues to risk endangering the health and balance of the global economy and financial system?

Likewise, the new liquidity facilities announced by the Fed amount to over US$7.5 trillion; of which US$4 trillion have been used. Those of the EU and other developed countries amount to US$6 trillion. India and China account for yet another US$800 billion. These bloated deficits and liquidity emissions are not trivial. They will have significant future side-effects. Will they succeed in staving off a long and deep recession? We do not know. Will they create post-recession complications that thwart sensible recovery? That likelihood may be higher than it appears now.

After these humongous deficits and liquidity emissions, what strategies will be deployed to bring deficits and money supply back under control; to generate fiscal surpluses and contract liquidity to avoid intractable post-recession inflation? If serious dislocation is to be avoided, and a soft re-entry to normalcy for the world is to be orchestrated, how long will that take? What will it mean for relative growth trajectories in the US, EU, Japan, China, India and other developing countries? What will it imply in terms of achieving essential adjustments: such as the US consuming and borrowing much less, reducing its debt to the world, while saving and investing much more? Will it lead to Europe finally acknowledging the unaffordability, unsustainability, uncompetitiveness, and counter-productivity of its basic economic model: i.e. that of an ever enlarging and intrusive welfare state, increasingly dependent on high-tax but inefficient government intervention to solve every personal/social problem and providing cradle-to-grave insurance, against every contingency? Or will some element of personal responsibility for healthcare, education, and managing personal risk be re-introduced?

Will China be convinced to consume/import more, while exporting, saving and investing less, for global balance to be restored? Will India take the steps necessary to consume, save and invest more, by reducing its fiscal deficit through public asset sales? Will it liberalise its financial system while relieving government of its ownership? Will it transform its labour and land laws/markets? Will it simplify and reform its absurd FDI, FII, NRI capital control regimes to achieve greater efficiency and productivity? Can India and China stave off protectionism by the US and EU by demanding an open global trading regime, while continuing to manage exchange rates (thus preventing adjustment from occurring automatically in global markets) and leaving their capital accounts partially closed? Are open current accounts compatible or congruous with conveniently perforated capital accounts indefinitely?

Such questions may be premature. But are they churlish? The answers may be elusive. So, should these questions not be posed? Indulging in my usual perversity let me ask again: does anyone have a post-recession exit strategy for correcting the fiscal/monetary imbalances we are temporarily but intemperately exacerbating to fight recession? Or have we become so myopic that we are unable to look beyond the next month? If so, the generation just entering the labour market should be seriously afraid about the inter-generational tax and other burdens they are about to inherit involuntarily.