The world is going through an economic crisis of unprecedented scale and magnitude. According to International Monetary Fund (IMF), ' the worst is yet to come', which should send a chill down the spine of policy makers and consumers alike. At times like this one gut reaction is to re-visit the roster of past economic crises, at least the major ones, to try to make sense of what may lie in store for the global economy from temporal and substantive perspectives. This may help in the determination of the policy regime to weather the present and clear danger. But like Tolstoy's unhappy families, no two economic crisis is the same, each having different background, context and configuration of causal factors. They are also unique in some respects about the way the details emerge. Policy response to them, therefore, does not allow to have the complacence of 'one-size- fits- all' for countries afflicted with the economic malaise. To use a biological metaphor, economic crises mutate over time making inter- temporal comparison difficult, at least in details. In spite of this difference there may be some commonality between the present and past crises with regard to causal factors and the policy responses best suited to address the crisis. What is more important, the time required by the present crisis to pan out may be imagined to know if the policy response will be for the short or medium haul. The time line of the crisis now evolving can be crucial in deciding on the policy mix under different scenarios.
The performance of economies at any time is evidenced by three core indicators viz. economic growth, employment and price level. With upward and more or less linear trajectory of the first two indicators and stable or moderate rise (compared to growth rate) of the third, an economy can be said to be on an even keel, cruising at a healthy speed. Crisis raises its head when these indicators reverse their trend. Depending on the magnitude and duration, an economy going through crisis takes on the moniker of 'slow down', 'slump, 'recession' or 'depression'. An economic slowdown occurs when the rate of economic growth slows in an economy. Countries usually measure economic growth in terms of gross domestic product (GDP),which is the total value of goods and services produced in a specific period of time. When the rate of economic growth declines by some percentage points compared to the period preceding immediately, it is estimated that the economy is slowing down and not growing as fast as it did previously.
In market economy, fluctuations in growth are explained by business cycles. The cycle peaks at an economic phase where growth has reached its highest point in the cycle, which is then followed by a decline in growth. If the decline is slow and of small magnitude it is called slowdown. A decline in growth lasting at least two consecutive years is called a recession which is a decline in total output lasting at least two consecutive quarters or at least six months. When the decline in growth of output (GDP) is severe and lasts more than a year accompanied by high unemployment, a depression is said to have set in. Employment is inversely related to recession and depression, that is with growth in economy. On the other hand, inflation is positively related to growth, going up when GDP growth posts upward trend.
Though fluctuations of GDP during business cycles are not perfectly synchronised across countries, a link can be identified, particularly between or among major trading partners. For instance, to give examples of recent periods, both United States (US) and the United Kingdom (UK) went into recession in early 1980s, grew well for rest of the decade, entered another recession in 1991, recovered for the rest of the decade, then slowed down in 2001. And both countries picked up steam in 2004.
Slow downs or recessions in major economies, not to speak of depression, impact on the economies of developing and emerging economies also but not to the same extent as in the case of major economies because of the lesser integration of these economies with the former through trade, land, capital movement. The degree of globalisation through movement of goods, services and capital determine the extent and intensity of transmission of the fluctuations of business cycles across economies. But when growth and employment decline due to non- economic shocks like pandemics or wars, all countries go through economic slowdown, sliding into recession, as the Covid -19 and now Ukraine war, have demonstrated.
Generally speaking, economic slowdowns may be confined to single or a group of countries. For instance, the debt crisis of Latin American countries in the Eighties or in some less developed countries of European Union (EU) more recently and the East Asian financial crisis of 1997 are instances of economic slowdown. These were of short duration and did not send the affected economies into recessionary spiral. But recession, not to speak of depression, is global in coverage depending on their integration in the global economy.
BUSINESS CYCLE THEORIES AND CAUSES OF ECONOMIC FLUCTUATIONS: Inadequate and scarcity of reliable statistics limited early economists to impressionistic theorising about fluctuations in economic activity. Still their thoughts and ideas provide important insights into the nature of macroeconomic fluctuations in the form of slowdowns, recession etc.
Many early business cycle theorists focussed on such external shocks as wars and weather. Although sections of an economy may benefit from war conflict wreaks havoc on both winners and losers Wars divert investment away from capital investment and destroy capital machinery, infrastructure and kills able - bodied labour( soldiers). War may also cause food crisis by disrupting supply of fertilizer and grains as the Ukraine war has done. Weather also impacts adversely on agricultural output if there is drought or flooding. A severe drought in the US farm belt in1988 drove up food prices globally. Under the broad head of weather the sunspot theory enunciated by the English mathematical economist, W. S. Jevons postulated that sunspots or nuclear storms on sun's surface affected weather and hence agriculture.
Though Karl Marx was in awe of economic progress under Capitalism (Communist Manifesto,1848), he condemned market economy as permitting the capitalist class to exploit workers. He predicted that capitalism would spasmodically expand and then contract, with each peak higher than its predecessor and each successive crash deeper than the last. He viewed business cycles as driven by increasing concentration of wealth in the hands of capitalists. He predicted that because of exploitation and increasing immiserisation the working class would overthrow the exploiters, the spark of revolution igniting during the depth of a deep depression.
Joseph Schumpeter, the Austrian economist, celebrated the entrepreneurial vigour and innovativeness of capitalism. In 1911, he proposed a long wave theory of business cycles in which development is fuelled when entrepreneurs initiate such innovations as discoveries of raw materials, new goods, technological advances, the opening of new markets. According to Schumpeter, economic growth peaks by the time society fully adapts to a new innovation. The next long-wave process is sparked by a new wave of innovation. Schumpeter also explained major innovations spawn spin- offs-- related inventions and birth of new industries.
Nikolai Kondratieff, a Russian economist, offered his own long- wave theory in the 1920s.On the basis of economic data for 1780 to 1920 he charted two complete long-waves (40 to 60 years each), with a third beginning in the early 1920s.The Great Depression of the Thirties attracted some economists to his idea that the world economy will boom and then bust every 40 to 60 years, so that another worldwide depression would begin between 1970 andb1990.But his prediction did not come true. Most economists believe Kondratieff's long waves as statistical accidents. But to his believers, the 1989-92 recession in America, reinforced expectations of a deep trough by the year 2000.
According to psychological theories, predictions of collapse can be prophetic because fear of a dismal future is often self- fulfilling. Psychological theory of business cycles focus on how human herd instincts make prolonged optimism or pessimism contagious. These theories help explain the momentum of swings initiated by such shocks as wars or changes in agricultural yields, the expected profitability of investments, or natural resource availability.
Once a real disturbance occurs, decision makers' reactions set off secondary shock waves -- the psychological part of a cycle. Business cycles unfold when firms develop similar expectations about the future and adjust their plans accordingly. Once set off, waves of pessimism or optimism seem to have lives of their own.
Psychological theories explain inertia in a recovery or downturn but do not address turning points in business cycles.
The preceding theories provide partial insights into some business fluctuations, but most modern economists have focussed on two general theories that compete in explaining broad cyclic activity: classical theory and Keynesian theory. As every economist knows, classical economics was not the creation of a single economist but, rather, represents a conglomeration of the thoughts of Adam Smith. Classical economics stresses coping with scarcity from the supply side as the key to macroeconomic stability, and supports market solutions to problems and minimum government intervention. In respect of business cycle classical economics relies heavily on the self- correcting power of automatic market adjustments to address macroeconomic instability, including high unemployment. Recessions create pressures for wages and prices to fall which, in turn, lead to growth of sales and expanding demands for labour. Opposite adjustments help prevent a rapid boon from overheating the economy.
But persistent 15 to 25 per cent unemployment during the worldwide Great Depression of the 1930s did not square with classical predictions. Could people wait for decades for the economy to self-correct? Or was the classical model flawed? John Maynard Keynes (1883-1946), the British economist concluded that capitalism might neither automatically nor quickly rebound from a depression. The theory Keynes formulated viewed macroeconomic problems as emerging primarily from the demand side, and recommended actively adjusting government policies to address instability. The demand-oriented model Keynes developed in his 1936 book, The General Theory of Employment, Interest and Money, dominated macroeconomics from the 1940s through the 1960s. According to Keynes, disruptions to aggregate demand being responsible for destabilising economy through recession or depression, the government should stimulate with expenditure to kick-start growth and promote employment. He assumed that idle productive capacity during depressed times allows production and income to stretch to accommodate growth in aggregate demand without spawning much inflationary pressure. But classical theory staged a comeback in the 1970s when Keynesian policies failed to cure the problem of stagflation (stagnant growth with high inflation) in America. Many observers, however, attributed the strong recovery of 1983-1990 to powerful Keynesian policies -- tax cuts, expanded government outlays and huge deficits. Classical economics suggest that any deviation from full employment represents disequilibrium that is a short run phenomenon that will be quickly remedied by Say's Law (supply creates its own demand) and flexibility of interest rates, wages and prices. The Keynesian perception of a short-run disequilibrium is very different. Disequilibrium occurs whenever plans for aggregate spending differ from aggregate income and output. What pushes an economy back to equilibrium? Classical reasoning suggests that since supply creates its own demand (Say's Law), aggregate spending automatically rises to accommodate the full employment level of output. Keynes responded saying that demand creates its own supply -- that supply passively adjusts to demand. In this context, spending and demand are synonymous. Keynesian fiscal policy emphasises use of government spending and tax policies to stimulate or contract aggregate spending and economic activity to offset cyclical fluctuations. Classical (supply side) fiscal policies rely on lower tax rates and minimal government spending to allow aggregate supply to grow. Keynesians and modern supply-siders (heirs to classical theory) agree that a fetish for balancing the budget was one reason why the economy, following what should have been a minor recession in 1929, continued tumbling downward until 1933.
The Keynesian Revolution stirred a counterrevolution by modern monetarists, who recognise some holes in older version of classical theory but reject any need for massive government intervention to stabilise economy. Their counterattack, led by Milton Friedman, began with a reformulation of the demand for money and arrived at the most widely accepted formulation of the new quantity theory of money.
FISCAL POLICY VS MENETARY POLICY: Classical economics and supply-side approaches lead to the conclusion that aggregate demand matters little in the long run. Keynesians and the new monetarists alike, however, focus on aggregate demand. Modern monetarists and contemporary Keynesians have different views in some respects e.g money supply but they also have some common ground. Their differences lie in different views of how important monetary policy is relative to fiscal policy. They don't believe that one matters to the exclusion of the other. Keynesians and monetarists agree that money matters but differ as to how much it matters. Keynesians argue that monetary growth will not raise spending or cut interest rates very much in a slump. Fiscal policy, on the other hand, is very powerful at such time, according to Keynesians. Adding government expenditure to investment boosts autonomous spending and via the multiplier, raises national production and income manifold.
Monetarists see the demand for money as relatively insensitive to interest rates but perceive investment as highly dependent on interest. Even a small increase in the money supply drives interest rates down sharply, according to the monetarists, which in turn strongly stimulates investment. Monetarists also see expansionary monetary policy as bolstering consumer spending because consumers have more disposable income and because lower interest rates make buying on credit easier and cheaper. Thus, modern monetarists view money as a powerful tool. Fiscal policy, favoured by Keynesians, has only a limited role according to monetarist reasoning because government spending does not raise injection to money supply as much as does even a small decline in interest rate. Moreover, monetarists object that government spending may crowd out private investment.
Keynesians and modern monetarists agree that when an economy is in full employment, growth of aggregate demand results in a rising price level. Both also agree that when an economy is in severe slump, increases in aggregate demand will restore full employment. They, however, disagree on the appropriate way to expand aggregate demand. Monetarists favour expansionary monetary policy to increase private investment and consumption, while Keynesians view that approach as ineffective because of widespread pessimism on the parts of workers, consumers, and business firms. Keynesians, therefore, favour expansionary fiscal policy.
The two major macroeconomic policies have been discussed at length above because these compete for attention of policy makers when they are seized with the problem of addressing economic fluctuations in the form of slump (slowdown in growth) recession and depression. In reviewing a few selective cases of major cases of economic fluctuations, including the present one, the role played by the two policies will be analysed.
CASE STUDY NO.1: Industrial market economies under capitalism have historically experienced alternating periods of expansion and contraction in economic activity. Economic fluctuations are the rise and fall of economic activity relative to the long-term growth trend of the economy. These fluctuations or business cycles vary in length and intensity, yet some features appears common to all. Analysts at the National Bureau of Economic Research (NBER) have tracked the US economy back to 1854. Since then America has experienced 32 peaks to trough fluctuations or cycles. The longest contraction of the economy lasted five and a half years from 1873 1879. In October 1929, the stock market began what was to become the deepest and severest economic contraction in America's history that has come to be known as the Great Depression of the 1930s. In terms of aggregate demand and aggregate supply, the Great Depression can be seen as a big shift to the left of the demand curve. Real GDP in 1929 was US$865 billion and the price level was 11.9 (compared to a 2000 base-year price level of 100).Though economists still debate the cause of the decline in aggregate demand, most agree that that the stock market crash of 1929 was the main trigger. Speculative derivative trading by traders in the US stock market magnified the 1929 crash and Depression. Beginning from October, 1929 grim business expectations cut investment, consumer spending fell, banks failed like nine pins, and money supply dropped. Panicked at the grim reaper-like depression, policy makers shut the economy off from foreign transactions. Soon an international protectionist war ensued which transmitted the consequences of American economy's woes to other countries, particularly Europe. All this contributed to a big decline in aggregate demand. The aggregate supply curve also shifted upward during this period, but the drop in aggregate demand was the dominant factor behind the great depression.
Because of the decline in aggregate demand, both the price level and real GDP dropped. Real GDP fell 27 per cent, from US$ 865 billion in 1929 to US$636 billion in 1933 and the price level fell to fell 25 per cent, from 11.9 to 8.9. As real GDP declined, unemployment soared, climbing from only 3 per cent of the labour force to 25 per cent during the four- year period the highest US rate ever recorded.
Before the Great Depression, macroeconomic policy was based primarily on laissez-faire, non-interference by government in the market, allowing market forces to self-correct and bring about equilibrium. But the Great Depression was so severe in its impact on the American economy and the public that economists and policy makers were forced to think out of the box. They remembered what the British economist John Maynard Keynes wrote about the free market: aggregate demand was inherently unstable, in part because investment decisions were often guided by the unpredictable 'animal spirits' of business expectations. Keynes, as has already been said, saw no natural market forces operating to ensure that the economy, if given a reasonable time to adjust, would get output and employment back on the right track. He proposed that a government facing depression should jolt the economy out of its travail by increasing aggregate demand. He recommended an expansionary fiscal policy to kick start the economy and thereby offset contraction. The government could achieve this stimulus either by increasing its own spending, or indirectly by cutting or indirectly by cutting taxes to stimulate consumption and investment. This will create a budget deficit but that should not deter a government as future increase in employment and output would bring in taxes at a higher level. According to the Keynesian prescription, the miracle drug of fiscal policy, involving changes in government spending and taxes, would compensate the instability of private spending, especially investment. The Keynesian approach has come to be known as 'demand- side economics,' as it focuses on how changes in aggregate demand could promote full employment. Once investment returned to normal level, the government's shock treatment would not be necessary to continue.
When President Roosevelt came to power in 1933, he was committed to a programme of vigorous intervention by the federal government to stimulate and underpin a recovery in the economy. The programme came to be known as the New Deal. However, partly because of the limits to the power of the presidency and the strength of opposition from sections of big business and the Supreme Court, it was not possible to implement the far-reaching state interventions in the economy envisaged in the New Deal and as a consequence it did not lay the foundation of a welfare state as the Keynesian ideas picked up by Lord Beveridge did in the United Kingdom (UK). Roosevelt, however, succeeded in passing The Employment Act of 1946 which essayed a clear responsibility to the federal government to promote maximum employment, production and purchasing power. The Act also required the President to appoint a Council of Economic Advisors to provide economic advice and report annually on the economy. The Roosevelt Administration also bailed out about 2000 banks that had collapsed during the Great Depression because of the Wall Street Crash. To prevent such banking collapse through their speculative investment in stocks and shares a law was passed separating the investment and banking functions of financial institutions.
All told, the economic policies adopted by developed industrialised countries drastically watered down the economic ideology of laissez-faire capitalism in the bastions of capitalism in America and Europe. The policy decisions taken during the 1930s also vindicated Keynesian theories about the role of fiscal and monetarist approaches to address problems of low levels of employment and low output caused by low level of investment by private sector. Monetary policy was not debunked but was relegated to the background, being of little consequence in times of economic contractions.
Ironically, Keynes's ideas were slow to find acceptance in his own country, the UK, although by 1920s he had been successful in convincing then Liberal prime minister Lloyd George to take up public works as a means of countering unemployment.
Whatever slack the implementation of New Deal in the US might have was more than compensated by investment and production of armaments for the second world war that led to increase in government spending by more than six-fold. In an ironical way, the powerful role of government was demonstrated by war and not a period of peace. Similar increase in public spending for re- armament in early '40s led to explosion of output and employment in UK, proving the effectiveness of free market.
CASE STUDY NO. 2- STAGFLATION (1975-1979): During the 1950s, American and British economy seemed to prosper without the added stimulus of fiscal policy. As a result, the 1960s came to be known as the golden age of Keynesian economics, a period when policy makers thought they needed to fine-tune the economy for top performance. During the early 1960s, nearly all advanced economies enjoyed low unemployment and stable growth with modest inflation. These economies enjoyed such a bounce toward the end of the decade that many economists and policy makers came to believe that the business cycle was history. In the early 1970s, however, economic fluctuations, resulting in recession, came back with a fury. Worse yet, the problems of recession were compounded by inflation which increased during 1974-1975 and of 1979-1980, giving the phenomenon a name - stagflation, stagnant growth with inflation. Confidence in demand-side policies were shaken by this strange and obstinate 'beast' and the golden age of Keynesian economics seemed to be heading for an unceremonious end. Monetarism, both of the classical and supply-side vintage, became poised to stake a claim for ownership or at least a dominant role in macroeconomics. What ended the golden age of Keynesian economics?
During the 1960s, federal spending in America increased on both the war in Vietnam and expenditures on social program at home. This combined stimulus increased aggregate demand enough that in 1968 the inflation rate rose to 4.4 per cent, after averaging only 2.2 per cent during the previous decade. Inflation climbed to 4.7 per cent in 1969 and to 5.2 per cent in 1970. These rates were so alarming that in 1971, President Nixon imposed ceilings on wages and prices. Those ceilings were eliminated in 1973, about the time that crop failures around the world caused grain prices to soar. Compounding these problems the Organization of Petroleum Exporting Countries (OPEC) cut its supply of oil causing oil prices to jump from US$ 20 per barrel to US$80. Crop failures and the OPEC action reduced aggregate supply, shifting left the aggregate supply curve leading to stagflation, a combination of stagnation in the economic aggregate output and inflation. Real GDP in America declined by about US$30 billion between 1973 and 1975, and unemployment climbed from 4.9 per cent to 8.5 per cent. During the same period, the price level jumped 19 per cent.
Stagflation hit five years later, fuelled again by OPEC cut backs. Between 1979 and 1980, real GDP declined but the price level increased by 9.1 per cent. Macroeconomic management during the Great Depression appeared not only out of date but ineffective as well. Because stagflation was on the supply side, not on the demand side, the demand management policy prescribed by Keynes seemed irrelevant. Increasing aggregate demand under the circumstances might reduce unemployment but would worsen inflation.
Increasing aggregate supply seemed an appropriate way to combat stagflation. Such a move would both lower the price level and increase output and employment. Attention therefore turned from aggregate demand to aggregate supply. A key idea behind supply- side economics was that the federal government, by lowering tax rates, would increase after-tax wages, which would give incentives to increase the supply of labour and other resources. According to proponents of the supply-side approach, the resultant increase in aggregate supply would achieve the goal of expanding real GDP and reducing the price level. But this was easier said than done.
In 1981, to provide economic incentives to increase aggregate supply, President Ronald Reagan and Congress cut personal income tax rates by an average of 23 per cent, to be phased in three years. It was hoped that aggregate supply would increase output and employment enough to increase tax revenue. The president and the Congress believed that the tax cuts would stimulate economic growth enough that the government's smaller share of a bigger national income would excel what had been its larger share of a smaller national output. But before the tax cuts took effect, recession hit in 1981, contracting output and the unemployment rate to 10 per cent.
During the period of stagflation growth in federal spending exceeded the growth in federal tax revenues. Federal budget deficits swelled just as it did during the aggregate demand enhancing years of the reign of Keynesian economics. The aggregate supply-oriented policy of the new monetarists led by Milton Friedman did not succeed in banishing the expansionist role of government promoted by Keynes. What became apparent was that both fiscal and monetary policy were useful tools for application during different phases of business cycles with the emphasis on either varying in changing circumstances. There was no room for the government and the central bank to work at cross-purposes, the independence of central bank notwithstanding. The Great Depression drove home the need for an interventionist government to promote employment and output, just as the subsequent experience with stagflation highlighted the role of central bank in containing inflation. For policy makers, it is not a question of whether to opt for fiscal policy or allow monetary policy to facilitate prudent macroeconomic management. Their responsibility is finding the right mix of the two important policy instruments to pursue the goal of growth with stability.
CASE STUDY NO. 3 - THE ASIAN FINANCIAL CRISIS (1997-1998): Most of the economic crises have taken place in industrially developed countries of the West, with spill over effects to emerging and developing countries. But the epic centre of the great financial crisis of 1997-1998 was in Asia, starting in the south-east Asian country of Thailand. The financial crisis started in July 1997 after the Thai government was forced to float baht, the national currency, due to lack of foreign currency to support its currency pegged to US dollar. Capital flight ensued almost immediately, setting off an international chain re-action. As the crisis spread, most of south-east Asia and later Japan and South Korea saw slumping currencies, devalued stocks and other asset prices. Among Asian countries, mainland China, Brunei, Vietnam, Singapore and Taiwan were less affected but all suffered from a loss of demand and business confidence.
During the financial crisis, foreign debt to GDP rose from 100 per cent to 167 per cent in the four large ASEAN countries in 1993- 1996 and then shot up beyond 180 per cent during the worst phase of the crisis. The effects of the crisis lingered through 1998, when growth in the Philippines dropped to zero. Only, Singapore and Taiwan proved relatively insulated from the shock but both suffered serious hits in passing. What were the causes of the widespread financial meltdown involving foreign currencies? Beginning from mid-Eighties and until 1997, Southeast Asian countries attracted almost half of total capital inflow into developing and emerging countries, attracted by the high interest rates. This resulted in sharp rise in asset prices. Some of these countries like Thailand, developed into an economic bubble, fuelled by hot money. But more of hot money was required as the bubble grew in size. The same happened in Malaysia and Indonesia where crony capitalism helped channel the foreign capital into unregulated sectors like real estate. Weak corporate and banking governance led to inefficient investment. In the mid-1990s Thailand, Indonesia, and South Korea had large private account deficits. The maintenance of fixed foreign exchange rate encouraged external borrowing which led to excessive exposure to foreign risks in both corporate and financial sectors.
In the mid-1990s, a series of external shocks began to change the economic environment. The devaluation of the Chinese reniminbi and the Japanese Yen following the Plaza Accord, and the increase in interest rate by Fed in America led to the emergence of a strong dollar. This made America a more attractive investment destination, leading to flight of the hot money from Asian markets. On the other hand, south Asian countries which had pegged their currencies to US dollar saw their exports lose out in international market as the dollar became stronger.
Many economist believe the Asian Financial Crisis of late Nineties was not the result of market psychology or semi-conductor technology but by policies that eroded incentives within the lender- borrower relationship. The resulting large amount of foreign capital that became avaiable generated a highly leveraged economic climate and pushed up asset prices to unsustainable levels. These assets, according to the analysts, eventually collapsed, causing individuals and corporations to default on debt.
The foreign ministers of ASEAN countries, in a meeting held during the crisis, believed that the well-co-ordinated manipulation of their currencies was a deliberate attempt to destabilise the regional economies. The Malaysian Prime Minister Mahathir Mohamad openly accused George Soros of ruining Malaysian economy with massive currency speculation. Be that as it may, the failure of ASEAN countries to pursue a transparent and pragmatic monetary policy cannot be ignored as being the main cause of the financial meltdown.
The resulting panic among lenders led to a large withdrawal of their capital, causing a credit crunch and series of bankruptcies. In addition, as foreign lenders began to withdraw their funds, the exchange market was flooded with domestic currencies of the south Asian countries, putting pressure on their exchange rates. The governments of these countries tried to stem this flood of local curency in the market by raising interest rate as alternate investment avenue and buying at fixed exchange rate, using their foreign exchange. Neither of these policy responses could be sustained because of insufficient foreign exchange reserves. When it became evident that capital flight could not be stopped, the authorities ceased defending their fixed exchange rates and allowed them to float. The resulting depreciation of currencies meant that foreign-currency denominated liabilities grew unsustainable in domestic currency terms, causing further bankruptcies and deepening of the crisis.
The Asian Financial Crisis was patently a case of monetary policy gone awry. As Joseph Stiglitz and Jeffrey Sachs pointed out, the real economy in the Asian countries affected by the crisis had very little to do for its making. Monetary policy that allowed foreign capital to move across borders without any control, pegging currencies to dollar rather than to a basket of currencies and offering interest at exorbitant rates were the contributory factors to the unprecedented financial crisis. But the International Monetary Fund (IMF), in its conditionalities attached to the bailout package, included contractionary fiscal policies for implementation by the Asian countries. Its role before the crisis, advising liberalisation of foreign exchange market, also came up for criticisms. Many commentators in retrospect criticised the IMF for encouraging the Asian countries down the path of 'fast-track capitalism' through liberalisation of the financial sector (eliminations of restrictions on capital inflows),maintenance of high domestic interest rates to attract portfolio investment and bank capital and pegging of national currency to dollar to reassure foreign investors against currency risks.
The IMF created a series of bailouts (rescue packages) for the most affected economies to enable them to avoid default, tying the packages to currency, banking and financial system reforms. The structural adjustment package (SAP) on which the IMF support was conditional, envisaged a series of reforms which included crisis- struck countries to reduce government spending and deficits and aggressively raise interest rates. The countries were told that these steps would restore confidence in the nation's fiscal solvency, penalise insolvent companies, and protect currency values. For most of the countries the conditionalties were bitter pills but they had no choice. The effects of the SAPs were mixed and their impact controversial. Critics noted the contractionay nature of these policies, arguing that in a recession, the traditional Keynesian approach was to increase government spending, prop up major companies and lower interest rates.
CASE STUDY NO. 4 - THE GREAT RECESSION (2007-2008): The financial sector crisis that pulverised the American economy during 2007-2008 has come to be known as the 'Great Recession' and like the Great Depression of 1930s its epic centre was also in Wall Street. Like the predecessor, the Great Recession also embroiled other industrialised countries, but more insidiously because of the greater integration of financial markets since the first catastrophy.
Lasting from December 2007 to June 2009, the economic downturn caused by the Great Recession was the longest since first world war beyond its duration, the financial crisis that began in 2007 was severer in several respects. Real GDP fell 4.3 per cent from its peak in Q4 of 2007 to its trough in Q2 of 2009, the largest decline in the post-war era. The unemployment rate, which was 5 per cent in December 2007 rose to 9. 5 per cent in June 2009 and peaked at 10 per cent in October 2009.
The financial effects were similarly outsized. Home prices fell approximately 30 per cent, on average, from their mid-2006 peak to mid-2009 while the S&P 500 index fell 57 per cent from its October 2007 peak to its trough in March 2009.
As the financial crisis and recession deepened, measures intended to revive economic growth were implemented on a global basis. The United States, like many other countries, enacted fiscal stimulus programmes that used different combinations of government spending and tax cuts. These programmes included the Economic Stimulus Act of 2008 and the American Recovery Act of 2009.
The US Federal Reserve' s response to the crisis evolved over time and took a number of non-traditional avenues. Initially the Fed employed 'traditional' policy actions by reducing the federal fund rates from 5.25 per cent in September to a range of 0-0.25 per cent in December 2008, with much of the reduction occurring in January to March 2008 and in September to December 2008. The sharp reduction in those periods reflected a marked downgrade in the economic outlook and the increased downside risks to both output and inflation. With the federal funds rate at its effective lower bound by December 2008, the Federal Open Market Committee began to use its policy statement to provide forward guidance for the federal funds rate. This guidance was intended to provide monetary stimulus through lowering the term structure of interest rates, increasing inflation expectations and reducing real interest rates. With the recovery from the Great Recession slow, the forward guidance was strengthened by providing more explicit conditionality on specific economic conditions, such as low rates of resource utilisation, subdued inflation trends, and stable inflation expectations. This was followed by the explicit guidance in August 2011 of' exceptional low levels for the federal funds rate at least through mid- 2013. This forward guidance can be seen as an extension of the Federal Reserve's traditional policy of affecting the current and future path of the funds rate.
In addition to this forward guidance, the Fed pursued two other types of ' non-traditional' policy actions. One set of non-traditional policies can be characterised as credit easing programmes that sought to facilitate credit flows and reduce the cost of credit. The second set of non- traditional policies consisted of the largest asset purchase programmes. With the federal funds rate near zero, the asset purchase was implemented to help push down longer-term public and private borrowing rates. Asset purchases provided support for the housing market, which was the epic centre of the crisis and recession. The Federal Reserve purchased approximately US$ 1.75 trillion of longer term assets.
The Fed's monetary policy strategy has continued to evolve, as evidenced by the present tilt towards Quantitative tightening and hike in basic policy rate. The pandemic and now the Ukraine war have changed the economic and financial environment beyond imagination.
The US economist Hyman Minsky, a Keynesian by conviction, wrote extensively about the de- stabilising dynamics of finance. In his work on financial stability he anchored Keyne's critique within an alternative theory of money which holds that the quantity of money in an economy is created by the interplay of economic forces rather than by an outside agency like central bank. Although portrayed as all powerful (and so responsible for financial instability) by Milton Friedman and the monetarists propelled to the forefront by 1970s stagflation, central banks like Fed can only indirectly and weakly control the private sector banks and their money creation, by setting the base interest rate. Minnsky charted the way in which the banking system would eventually end up moving to ' 'speculative finance', pursuing returns that depended on the appreciation of asset values rather than the generation of income from productive activity (Minsky, H.P., Finance and Stability: The limits of Capitalism,1993). Banks and investment funds may believe they are deriving income from new production, and their individual risk models will show that they will survive most conceivable financial shocks because of the diversification of their portfolios. But their incomes are ultimately transfers from other financial firms, and can suddenly dry up when one firm's inability to meet a transfer obligation forces others to do so in turn. That is what happened when Lehman Brothers, the American investment bank, collapsed in 2008, thereby heralding the Great Recession. The fallout can be measured not only in output and job losses but also by the amount of money government has to pour into private banks, because they are ' too big to fall'. The amounts figured in bailing out banks are enormous. In the US, the Fed embarked on three different Quantitative Easing (QE) schemes, totalling US$4.2 trillion, over the period 2007-14. In the UK, the Bank of England (BoE) undertook 375 billion pound sterling as QE between 2009 and 2012, and in Europe, the European Central Bank committed 60 billion euro per month from January 2015 to March 2017.
Now let us turn to the causes that led to the financial crisis which has been labelled as the Great Recession. The causes of the financial crisis included a combination of vulnerabilities that overwhelmed the financial system in America and Europe, along with a series of triggering events that began with the bursting of the housing sector bubble in the US in 2007. When housing prices fell and homeowners began to abandon their mortgages, the value of mortgaged-backed securities held by investment banks fell sharply, causing several to collapse, Lehman Brothers was the first major one, to do so. Because of the depreciated value of houses and the near junk status of financial assets created on them, the event came to be described as 'subprime mortgage crisis'. The combination of banks unable to provide funds to business and homeowners' inability to pay their mortgage loan caused the recession of 2007-8.Thus, the recession began when the US housing market went from boom to bust and large amounts of mortgage- backed securities and derivatives lost significant value. According to the Financial Crisis Inquiry Commission ., the recession was avoidable. The Commission cited several key contributing factors that led to the downturn. First, the report identified failure on the part of the government to regulate the financial industry. The failure to regulate included the Fed's inability to curb toxic mortgage lending. Secondly, there were too many financial firms taking on too much risk. The shadow banking system, which included investment firms, grew to rival the depositiry banking system, but was under no scrutiny or regulation. In other words, financial institutions evaded regulation through shadow banking. When the shadow banking system failed, the outcome affected the flow of credit to banks, business and individuals. Other causes identified included excessive borrowing by house owners to pay mortgage and by invest banks to buy derivatives from other banks for speculative purposes. Derivatives and syndication of the same asset was carried out to such lengths that ultimately the asset was reduced to junk But as long as the illusion of asset lasted, bubbles were created centring that asset. Mortgages of houses at low interest rate to unqualified borrowers ( not credit worthy) ultimately led housing prices to fall, leaving many house owners under water. This in turn, severely impacted the market for mortgaged-backed securities held by banks and other financial institutions.
The steps taken by the American and developed countries' governments have already been alluded to. While summing up, it suffices to say that except increasing marginal income tax on the super-rich the fiscal policy implemented to ensure recovery from the Great Recession has been as vigorous as during the Great Depression in Thirties. The US Federal government implemented a massive fiscal programme to stimulate the economy, spending US dollar 787 billion in deficit financing under the American Recovery and Reinvestment Act. As regards the monetary policy, the Fed lowered the key interest rate to nearly zero to promoter recovery. In an unprecedented move, Fed provided banks with a staggering US$77 trillion of emergency loans in a policy that came to be known as quantitative easing (QE).This massive monetary policy response in some ways represented a doubling down on the early 2000s monetary expansion that fueled the housing bubble in the first place.
Following these policies, perhaps, in spite of them, the economy gradually recovered. Real GDP bottomed out in the second quarter of 2009 and regained its pre- recession peak. Financial markets recovered as the flood of liquidity washed over Wall Street in the second quarter of 2011. Critics of the policy response and how it shaped the recovery argue that the tidal wave of liquidity and deficit spending did much to prop up politically committed financial institutions and big business at the expense of ordinary people and may have delayed recovery by tying up real economic resources in industries and activities that deserved to fail.
CASE STUDY NO.5 -- COVID PANDEMIC (2020-2022): The Covid pandemic that spread like wildfire across the world, was a Black Swan that very few anticipated but wreaked havoc, taking heavy toll in human lives and brought economies literally to a standstill. Not only countries, developed and developing, were totally unprepared to deal with the health emergency to save infected people and protect others, complete lockdowns were declared closing offices, factories and all public facilities except hospitals and clinics. Everyone was forced to idleness indoors, losing income. As the lockdowns prolonged, hunger, even starvation, stared in the face of many, particularly those with low incomes and no savings. Production of output and provision of services came to a halt. The economic consequences of the pandemic amounted to a recession but no country described the catastrophe as such.
Notwithstanding the lack of labelling, governments in all countries had to undertake massive fiscal and monetary measures to cope with the economic impact of the unprecedented pandemic, in addition to gearing up the health services and medical care industries.
In Japan, the coronavirus did not spread as quickly as in many European countries (Italy) or the US. However, Japan announced a robust programme to support the economy in the wake of the pandemic. At first, US$ 300 billion was allocated to keep the economy moving. Before long the amount was increased to US$990 billion, about twice as much as during the 2007-2008 financial crisis. Direct financial support was provided to the worst affected sectors, such as aviation and hospitality. Interest free loans were given to small and medium-sized industries and businesses.
In Germany, 1.4 trillion euros were allocated, of which 400 billion were given as state guarantee on interest-free loans for business and industries, while 156 billion were given as direct assistance to small and medium industries. Another 50 billion were allocated to support self-employed people. In addition, 100 billion were kept as reserve in case shares of industries had to be bought to save them from bankruptcies. Finally, 100 billion euro were allocated to the German State Development Bank for its special programme.
The British government distributed more than 350 billion pound sterling as the first tranche to different sectors. The first allocation was used to guarantee loans to small business, direct cash subsidies to small businesses, subsidies for people on furlough and to cover the budget deficit due to partial cancellation of taxes for businesses.
America spent the most in the world to help individuals and business firms affected by the pandemic. Overall, America planned to spend more than US$2.2 trillion to overcome the economic consequences of the pandemic. Of this total, a quarter was given as direct assistance to citizens, and another US$367 billion was spent by the federal government to support small businesses. Another US$500 billion was allocated to finance the affected sectors, support cities and the states, and finally, expanded unemployment insurance amounting to US$250 billion dollar.
Immediately following the outbreak of the pandemic, the government of Bangladesh announced a comprehensive stimulus package that relied more on bank financing because of limited fiscal space. The contribution of government was limited to subsidy for bank interest and guarantee given for certain loans to be given by banks. Only direct cash transfer (Tk 25 billion) for poor and low income families was financed by the government. Bangladesh, like most emerging and developing countries, therefore, can be said to have 'monetised' fiscal policy in respect of the stimulus given to sectors of the economy affected by the pandemic. Reliance on bank's participation meant not all affected sectors benefitted from the stimulus programme. For instance, small and medium scale business and industries were largely unnerved by banks because those were not their known clients and were thought to lack credit- worthiness.
The impact of Covid-19 on the economy of Bangladesh has been transmitted through two main channels : (1) depressed domestic demand and supply disruptions; and (2) slowdown in global economic activities affecting global trade and international financial flows. According to BRAC Institute of Governance and Development, after the stimulus package spending, amounting to 3.6 per cent of GDP, was spent the adverse impact of the pandemic on the economy could be expected to fall to 2.9-7.2 per cent under three alternative shock scenarios, implying that because of government policy measures, the impact on overall GDP could be 0.6 percentage points lower under the low shock scenario. Under both medium and high shock scenarios, the impact would be around 1 percentage point lower. On exports, the impact of the stimulus package was calculated to be between 3 and 5 percentage points while for imports the comparable impacts are in the range of 2.5--3.9 percentage points..
According to the World Economic Outlook (WEO), 2021, published by IMF, the global economy contracted by 3.5 per cent in 2020, a 7 per cent loss relative to the 3.4 per cent growth forecast made in October, 2019. While virtually every country covered by the IMF posted negative growth in 2020, the downturn was more pronounced in the poorest parts of the world.
While the global economy was expected to recover by the end of 2021, the level of GDP at the end of 2021 in all countries taken together was projected to remain below pre- pandemic baseline. As with the immediate impact, the magnitude of the medium- term cost was projected to vary significantly across countries, with the emerging and developing countries suffering the greatest loss. The IMF Report (2021) projects that in 2024 the world GDP will be 3 per cent ( 6 per cent for low income countries) below the no-Covid scenario. Along the same lines, it has been separately estimated that African countries' GDP would be permanently 1 per cent to 4 per cent lower than in the pre-Covid outlook, depending on the duration of the pandemic.
The pandemic triggered a health and fiscal response unprecedented in terms of speed and magnitude. At the global scale, the fiscal support reached nearly US$16 trillion (around 15 per cent of GDP) in 2020. However, the capacity of countries to implement such measures varied significantly as has been pointed out above citing instances of selected countries. Three important pre-existing conditions have been identified that magnified the shock caused by the pandemic.: (a) Fiscal space: The capacity to support households and firms largely depends on access to international financial markets; (b) State capacity: Fast and efficient implementation of policies to support households and firms requires a substantial state capacity and well- developed tax system and infrastructure, and (c) Labour market structure: A large share of informal workers facing significant frictions to adopt remote working and high levels of poverty and inequality deepen the deleterious impact of the crisis.
Additionally, the speed and the strength of the recovery will be crucially dependent on the capacity of the government to acquire and roll out the Covid vaccine.
CASE STUDY NO. 6 -- THE UKRAINE WAR (FEBRUARY, 2022-...): By early 2022, most of the countries affected by the pandemic were in the process of achieving recovery, and some had reached the pre- pandemic level of output and employment. Two problems ( rather one) hindered progress in this regard: supply chain disruptions that constrained manufacturing sector dependent on off- shore suppliers of inputs and rising inflation due to expenditures on stimulus packages and higher cost of production on account of supply disruptions. With inflation rate above 8 per cent, a historically high figure, both the American and the UK central banks reversed their easy money policy of near zero interest rate and quantitative easing (QE) through purchase of treasury bonds and bills that had been pressed into service during the Great Recession of 2007 and 2008 and continued unabated. The American Fed raised basic policy rates thrice in 2022 at the rate of 75 basis points while Bank of England raised the rate by 50 basis points. The European Central Bank (ECB) bided for time as the rise in inflation was slower than in America and the UK and also because of possible impact on relatively weak members like Italy, Spain, Portugal and Greece, all of which underwent wrenching debt crisis in 2012.
The ' new normal' after the pandemic and the placidity of recovery through policy adjustment was subjected to sudden jolt by the outbreak of war in Ukraine where Russian army invaded in full fury in February 2022.For the global economy, it was as destabilising as the pandemic, perhaps worse because of the polarisation effect. The western alliance, supporting Ukraine, immediately slapped a slew of economic sanctions on Russia which cut the country off from international trade and finance. But Russia is a major supplier of food grains, oil and gas soybean oil and fertiliser. The war immediately increased the prices of these items, fuelling inflation. The prevailing high levels of inflation in all countries jumped even higher, placing monetary authorities in a great quandary. The historic high levels of inflation left no alternative to continuing with the tight monetary policy that countries had been following before the war. But this this sent cost of living sky rocketing. The present government in the UK has proposed a cap on the monthly bill on energy use. The EU countries are yet to reach consensus on price cap regarding gas from Russia. In the midst of the deepening crisis and apprehension about recession, ECB is concentrated on the monetary tools that it has at its disposal , changing interest rates, leaving the welfare role to governments. Unlike in the UK, no government in Europe has yet taken any fiscal measure to give relief to consumers. Protest marches on the streets of Berlin and Paris have revealed simmering public grievances over rising cost of living. If the policy to contain and lower inflation to the targeted rate of 2 per cent does not succeed stagflation may be the result, which will bring fiscal policy measures to the forefront of government agenda.In the absence of increased tax revenue governments in developed countries will resort to borrowing that will keep up the trend of budget deficit.
Looking at the two countries at war, it is seen that the eight month- old war has already destroyed vital infrastructures across Ukraine. According to World Bank, Ukraine economy will contract 45 per cent by the end of 2022, while Russian economy will suffer a decline of 11.2 per cent. Being the third largest oil producer and a major supplier of wheat, corn, sunflower and fertiliser in the world, Russia has not been affected by the freezing of assets and sanctions imposed by the western alliance.
IMF's global forecast for 2022 has remained unchanged at 3.2 per cent, while forecast of growth for next year is lowered to 2.7 percent,02 percentage points lower than in July this year. According to IMF, the 2023 slowdown will be broad-based, with countries accounting for one- third of the global economy poised to contract this year or next. The three largest economies, America, China and the EU will continue to stall. Overall, this year's economic shocks will re-open wounds that were only partially healed post- pandemic, according to IMF .'In short, the worst is yet to come, and for many people, 2023 will feel like recession.' wrote an IMF staffer recently.
Developing countries like Bangladesh are trying to contain inflation with selective quantitative restrictions on imports and giving emphasis on growing more food and raising price on oil products to encourage saving. Both the expansionary monetary and fiscal policies unleashed during pandemic have been reined in. Austerity in public and private expenditures is being emphasised. But at a time of rising cost of living the call for belt-tightening is not likely to assuage pent up feelings of resentment, even anger. Public expenditures to give some relief to the low-income group and the poor will have to be undertaken sooner or later.
CONCLUSION: The review of the five case studies on economic crisis, beginning from the Great Depression of 1930s to the most recent one resulting from the Ukraine war seems to suggest a few conclusions.
The first is that the major economic crises in the past have been the result of the way forces play out in the marketplace without a vigilant regulator. Naked and unbridled profit motive have led operators in free market to pursue their individual and group interests, ignoring the commonweal of the public. The existing institutions and laws and absence of regulation have given the few to enrich themselves at the expense of many. In the real economy of manufacturing goods, the entrepreneurs and executives working for shareholder, work for profit but their power to pursue this goal is not untrammelled and scope for their evading regulation is very limited, except for having 'creative auditing ' of their balance sheets But in the murky world of high finance where derivatives and securitisation of investment instruments create bubble it is almost impossible to see through the arcane stratagem until the bubble bursts as was the case with the subprime mortgage crisis The problem with the financial market in developed capitalist countries, where most of the economic crises originate, is that banks do not find their traditional role of intermediation ( between depositors and debtors through banks) very challenging, that is rewarding That is why they manage to get the protective fire wall between banking of the intermediation type and high flying investment demolished. Once the distinction between traditional banking and investment banking is abolished, speculative and manipulative finance has almost a free run of the financial market; almost because the so called regulators are either complacent or complaisant of the Gordon Geckos of the market who are generous enough to take care of them also. In the wake of the Great Recession of 2007-8, Paul Volcker, former Fed chairman, argued for some kind of return to Glass-Steagall Act of 1933, which separated commercial banking from investment banking. This firewall eroded in the 1980s and 1990s under pressure of a powerful lobby, finally disappearing altogether with the Gramm-Leach-Biley Act of 1999.The breakdown meant that banks pursued high-risk activities that resembled gambling more closely than banking. Fortunately, banks in developing countries have not yet attained the venality as that of their counterparts in developed countries But in countries like Bangladesh, the policy of allowing banks to invest in stock market appears becoming more liberal as to the ceiling which is creeping upward. This does not augur well for smooth running of banks.
The second conclusion that can be drawn from the review is that while addressing economic crisis, though both monetary and fiscal policies are used, the fiscal policy has often to bear the greater burden. This is because monetary policy takes a longer time than fiscal policy to bring about change, though it is relatively more effective in giving incentives or causing disincentives through interest rates. For implementation of decisions like bail- out of distressed banks or cash transfer to target groups , fiscal policy has been found far better equipped and capable than monetary policy.
The third conclusion follows from the second. Sudden or growing obligations of the government to spend during emergencies ( like pandemic) and for capital overheads(roads, bridge, ports) require exceeding revenue receipts resulting in deficit budgets. Budget deficits are met by the government through borrowing ( from banks, financial markets, external sources) which becomes public debt. When budget deficits become chronic, the size of public debt grows in volume. In developed countries like America there is no limit to public debt except that approval of Congress is required to go above the prevailing debt ceiling. In developing countries like Bangladesh there is no legal limit to public debt. It is guided by consideration of prudent macroeconomic management. When the economy grows, providing additional capacity to service debt, the limit is determined by the trend rate of growth.
To sum up, economic crisis is inevitable because of developments intrinsic to an economy i e. faulty macroeconomic management or due to external factors (war, pandemic). Fine-tuning macroeconomic policies for better management of the economy is a continuous process and a modicum of preparedness for unanticipated events can go a long way in blunting or attenuating the impact of economic crises.
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