Global meltdown: Its nature and fallouts
Tuesday, 11 November 2008
Abul Maal A Muhith
The situation of 1929 when the great depression began was not very different from that of today in terms of easy availability of money. This time the investment in real estate is the culprit whereas speculative investment in the Wall Street brought about the collapse of the financing institutions in 1929. Banks at that time were too many in USA and they were totally unregulated. They had mobilised huge deposits of $49 billion in an economy of $103 billion. Half of the banks closed because of bad debt and deposits of $17 billion or 29% were lost. The US GDP declined by 33% in four years giving rise to unemployment at 25%, up from only 3.0% in an over-heated economy in 1929. Investment continued to be negative till 1935 when public works began to relieve the situation. US was a net exporter of capital then at about $ 740 million a year but it declined to $ 540 million by 1935. There was worldwide default on loan repayment. Not till 1940 did the US GDP grew back to $100 billion. Unemployment came down to 5% in 1942, thanks largely to the Second World War.
The easy availability of money at the beginning of the new millennium shot up housing price in USA to absurd limits. This also led to some speculative investment in information communication & technology (ICT) sector. The growth of domestic credit this time has been phenomenal in the global context essentially because of the profligacy of USA. President Clinton had cleaned up budget deficits by 2000 but President Bush with his defense spending and tax cuts and irresponsible financial stance increased the deficit to an unprecedented level. While globally domestic credit expanded to 145 per cent of the real wealth of the world at the beginning of 2007, in USA that credit growth was the highest at 270% of its GDP, although the average growth in the developed world was 166%.
Low interest rate and no contraction in money supply created the bubble of real estate boom. The mortgages gave good business to the banking sector. And relaxed regulations did not halt spiraling of secondary loans. The continuous erosion of shareholders' say in the affairs of business companies and the greed and authoritarian attitude of the management weakened the capital base of companies while money supply continued to increase with the help of new instruments of credit. The integrated banking system of the developed world picked up US profligacy rather abundantly.
That is why US melt-down affects the world so badly and disproportionately to its share in real wealth or two-way trade of the global economy. In 2005 US economy accounted for 34% of world economy of about $ 45 trillion and although it is not what it used to be as the dominant share of the global economy it is still quite huge while the growing economies (i.e., the developing countries) account for a bare 19 per cent or $10 trillion. Again world trade even though it has increased enormously in the recent past to over 10 trillion still accounts for only 22 per cent of global wealth. Two way trade, however, is 45% and that is important to note because US imports are a little less than double of its exports. USA accounts for 17 per cent of imports although its exports account for only 10 per cent of world exports. The management of US economy actually seems to have been dominated by cronyism, greed and wrongful actions of business executives and investors in the style of Indonesia of 1998. The supervision by the watchdog institutions became lax due to philosophical orthodoxy about the magic of the private sector as admitted by Alan Greenspan.
What is happening and may happen: The concerted action by the rich countries of the world, however, is so very different this time from that in 1929. There has been rapid policy coordination and bold measures were taken to prevent panic. Almost all developed countries and some rich countries such as UAE have chipped in to guarantee the health of the financial institutions of their countries who have huge foreign (meaning mainly American) exposure. State intervention rather than nationalization of banks and financial institutions have been made boldly to retain the flow of credit and prevent closure of broke financial institutions.
Probably the results will not be discernible in six months or even more. But we are sure that the depression that will occur in USA will not be of that order to await rejuvenation in the tenth year as it did in the 1930s. The recession in USA may itself not need more than three to four years to recover. There also may not be a global depression this time and total negative growth may not be there in all countries. But there will, of course, be some deceleration in economic growth in most countries. The unfortunate stance is that the henhouse has been left to the wolves who devoured the hens in the first instance. Despite the existence of a huge international public sector where others have some voice, it has been left out as an observer or outside advisor on the side.
It augurs well that the conference of the Twenty will be held on November 15 in Washington soon after the Presidential election in USA. The participants in the conference between them account for 85 per cent of world wealth and 66 per cent of world population and also of export trade. There are nine developed countries -- Australia, Canada, France, Germany, Italy, Japan Russia, UK and USA -- and the European Union. From the developing countries there are another ten countries, namely Argentina, Brazil, China, India, Indonesia, Mexico, Saudi Arabia, South Africa, South Korea and Turkey. This practically leaves out the vast group of low income countries who will suffer the most for no fault of their own. India is the only country of this group and it is a marginal member but all the least developed countries mainly of Africa and Asia do not even get an opportunity to state their case, not to speak of prescribing remedies. A representation from them should be considered even if the group may not have clout enough to influence the course of action. The conference will be long and difficult as it will search for new architecture for the global economy. But its immediate effect will be an assessment of the crisis and a demonstration of solidarity that will determine its course and give an idea of the fall-out effects in other countries. It is very important for a charting of the course by the weakest economies and that is why their presence is important. They have to find out and understand where they may end up three to six months later. It is also not clear as to what role the international public sector led by the UN with IMF, WTO and World Bank will play there.
What may happen in terms of competitive devaluation and trade shrinking is another question of great importance. Possibly it will also be controlled by concerted action against any panic. Competitive devaluation and trade restrictions or preferences are not likely this time to be the dominant features of national economic management.
There will surely be some cautious devaluation but competitive devaluation can be avoided by some innovative international intervention. The reserves of surplus countries, including sovereign funds, are very huge (about $6.0 trillion for 10 countries) and they can be used to arrest any severe trade contraction. Countries with huge reserves such as China (who is also shooting for the top position as an export earner), UAE, Japan, Russia, India, Norway, Taiwan, South Korea should be persuaded to lend their reserves to countries that may face severe trade squeeze. Prudential management of financing trade is an area for pro-active and imaginative action that can ease the pain of adjustment.
But how is the so-called melt-down going to affect various groups of countries this time? Last time all economies shrank. There was wealth loss of about 18% by the developed and 12% by the others in four years and trade loss was 27% during the period for the world as a whole. The recession this time is not likely to be that deep because of prompt and bold international action.
It is likely that developing countries will experience deceleration in economic growth and exports may suffer in some countries because of their extreme dependence on markets in developed countries. What will be the fate of capital flow? Recession will surely cause a decline but the steps taken by developed countries for arresting financial collapse are likely to prevent a substantial decline.
The situation of 1929 when the great depression began was not very different from that of today in terms of easy availability of money. This time the investment in real estate is the culprit whereas speculative investment in the Wall Street brought about the collapse of the financing institutions in 1929. Banks at that time were too many in USA and they were totally unregulated. They had mobilised huge deposits of $49 billion in an economy of $103 billion. Half of the banks closed because of bad debt and deposits of $17 billion or 29% were lost. The US GDP declined by 33% in four years giving rise to unemployment at 25%, up from only 3.0% in an over-heated economy in 1929. Investment continued to be negative till 1935 when public works began to relieve the situation. US was a net exporter of capital then at about $ 740 million a year but it declined to $ 540 million by 1935. There was worldwide default on loan repayment. Not till 1940 did the US GDP grew back to $100 billion. Unemployment came down to 5% in 1942, thanks largely to the Second World War.
The easy availability of money at the beginning of the new millennium shot up housing price in USA to absurd limits. This also led to some speculative investment in information communication & technology (ICT) sector. The growth of domestic credit this time has been phenomenal in the global context essentially because of the profligacy of USA. President Clinton had cleaned up budget deficits by 2000 but President Bush with his defense spending and tax cuts and irresponsible financial stance increased the deficit to an unprecedented level. While globally domestic credit expanded to 145 per cent of the real wealth of the world at the beginning of 2007, in USA that credit growth was the highest at 270% of its GDP, although the average growth in the developed world was 166%.
Low interest rate and no contraction in money supply created the bubble of real estate boom. The mortgages gave good business to the banking sector. And relaxed regulations did not halt spiraling of secondary loans. The continuous erosion of shareholders' say in the affairs of business companies and the greed and authoritarian attitude of the management weakened the capital base of companies while money supply continued to increase with the help of new instruments of credit. The integrated banking system of the developed world picked up US profligacy rather abundantly.
That is why US melt-down affects the world so badly and disproportionately to its share in real wealth or two-way trade of the global economy. In 2005 US economy accounted for 34% of world economy of about $ 45 trillion and although it is not what it used to be as the dominant share of the global economy it is still quite huge while the growing economies (i.e., the developing countries) account for a bare 19 per cent or $10 trillion. Again world trade even though it has increased enormously in the recent past to over 10 trillion still accounts for only 22 per cent of global wealth. Two way trade, however, is 45% and that is important to note because US imports are a little less than double of its exports. USA accounts for 17 per cent of imports although its exports account for only 10 per cent of world exports. The management of US economy actually seems to have been dominated by cronyism, greed and wrongful actions of business executives and investors in the style of Indonesia of 1998. The supervision by the watchdog institutions became lax due to philosophical orthodoxy about the magic of the private sector as admitted by Alan Greenspan.
What is happening and may happen: The concerted action by the rich countries of the world, however, is so very different this time from that in 1929. There has been rapid policy coordination and bold measures were taken to prevent panic. Almost all developed countries and some rich countries such as UAE have chipped in to guarantee the health of the financial institutions of their countries who have huge foreign (meaning mainly American) exposure. State intervention rather than nationalization of banks and financial institutions have been made boldly to retain the flow of credit and prevent closure of broke financial institutions.
Probably the results will not be discernible in six months or even more. But we are sure that the depression that will occur in USA will not be of that order to await rejuvenation in the tenth year as it did in the 1930s. The recession in USA may itself not need more than three to four years to recover. There also may not be a global depression this time and total negative growth may not be there in all countries. But there will, of course, be some deceleration in economic growth in most countries. The unfortunate stance is that the henhouse has been left to the wolves who devoured the hens in the first instance. Despite the existence of a huge international public sector where others have some voice, it has been left out as an observer or outside advisor on the side.
It augurs well that the conference of the Twenty will be held on November 15 in Washington soon after the Presidential election in USA. The participants in the conference between them account for 85 per cent of world wealth and 66 per cent of world population and also of export trade. There are nine developed countries -- Australia, Canada, France, Germany, Italy, Japan Russia, UK and USA -- and the European Union. From the developing countries there are another ten countries, namely Argentina, Brazil, China, India, Indonesia, Mexico, Saudi Arabia, South Africa, South Korea and Turkey. This practically leaves out the vast group of low income countries who will suffer the most for no fault of their own. India is the only country of this group and it is a marginal member but all the least developed countries mainly of Africa and Asia do not even get an opportunity to state their case, not to speak of prescribing remedies. A representation from them should be considered even if the group may not have clout enough to influence the course of action. The conference will be long and difficult as it will search for new architecture for the global economy. But its immediate effect will be an assessment of the crisis and a demonstration of solidarity that will determine its course and give an idea of the fall-out effects in other countries. It is very important for a charting of the course by the weakest economies and that is why their presence is important. They have to find out and understand where they may end up three to six months later. It is also not clear as to what role the international public sector led by the UN with IMF, WTO and World Bank will play there.
What may happen in terms of competitive devaluation and trade shrinking is another question of great importance. Possibly it will also be controlled by concerted action against any panic. Competitive devaluation and trade restrictions or preferences are not likely this time to be the dominant features of national economic management.
There will surely be some cautious devaluation but competitive devaluation can be avoided by some innovative international intervention. The reserves of surplus countries, including sovereign funds, are very huge (about $6.0 trillion for 10 countries) and they can be used to arrest any severe trade contraction. Countries with huge reserves such as China (who is also shooting for the top position as an export earner), UAE, Japan, Russia, India, Norway, Taiwan, South Korea should be persuaded to lend their reserves to countries that may face severe trade squeeze. Prudential management of financing trade is an area for pro-active and imaginative action that can ease the pain of adjustment.
But how is the so-called melt-down going to affect various groups of countries this time? Last time all economies shrank. There was wealth loss of about 18% by the developed and 12% by the others in four years and trade loss was 27% during the period for the world as a whole. The recession this time is not likely to be that deep because of prompt and bold international action.
It is likely that developing countries will experience deceleration in economic growth and exports may suffer in some countries because of their extreme dependence on markets in developed countries. What will be the fate of capital flow? Recession will surely cause a decline but the steps taken by developed countries for arresting financial collapse are likely to prevent a substantial decline.