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The Bends In The V-Curve

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The easy thing to do is to say what it is not going to be like. Free-market ideas are not going to be taken for granted. Banks and other financial institutions are not going to be given the benefit of doubt. Credit is neither going to be abundant nor cheap. American and British consumers are not going to be adding to their debts, year after year.

It is much more difficult to describe the new world in more positive terms. Still, as the rich economies show signs of bottoming out, as China and India both see their growth rates picking up a little, and as oil and commodity prices move upwards again, we can at least assemble some clues about what the next few years might look like.

For the western economies, the clues provide a clearer picture. Their financial systems and public finances are in such poor condition that they are likely to dominate economic performance for some time. Banks and other providers of capital are going to be risk-averse, desperate to rebuild their profit margins and capital reserves. So borrowing costs and terms are going to be onerous, slowing down the recovery of business investment.

That situation will prevail even if widespread fears of inflation prove overdone. If, however, inflation does start to rise as a result of the extraordinary monetary expansions by western central banks, then borrowing costs will rise even more sharply as bond investors demand protection against inflation. My suspicion is that inflation is not a real prospect in the western economies, because there is so much spare capacity in those countries. And rising borrowing costs will keep it that way, besides slowing down any initially rapid rebound.

All the central bank governors and economics ministers of the western economies talk constantly about the need for an “exit strategy” from their expansionary monetary and fiscal policies. As Christina Romer, chair of Barack Obama’s Council of Economic Advisors, writes in a guest column in The Economist of 19 June, the danger is that they will try to “exit” too early, risking a repeat of what happened in 1937. Then, after a rapid rebound of the US economy from the first and worst period of the Great Depression, a premature tightening of monetary policy brought about a sharp recession in 1937-38.

What of India, China and other emerging economies? First, we must remind ourselves that there are two different (if related) economic cycles, not one. Yes, there is the financial crisis that caused a slump in demand in western economies, along with a big drop in world trade. But also there is the more conventional cycle in emerging economies caused by the inflationary booms of the first half of 2008, along with the drastic monetary measures to try to bring them under control.

China and India both had a policy-induced slowdown, which has been exacerbated by the western financial crisis. As their monetary policies have been put into reverse now, and as both governments have brought in fiscal stimulus packages, so the revival in growth has been quite swift. While the shape of the western recession can be described as an ‘L’, or more optimistically as the Nike symbol, with a sharp drop followed by a long slow recovery, the shape of the Indian and Chinese recoveries looks likelier to be a ‘V’.

Tight global financial conditions will still hamper India’s growth, given the country’s borrowing needs — especially the ambitious infrastructure proposals being laid out by the new transport minister, Kamal Nath. China will be less affected by such trends, as it is financially self-sufficient.

Both countries, however, could face a danger of renewed inflation. The slower their growth rebound is, of course, the less likely inflation is. But the conditions that brought about 2008’s inflation spurt, a mixture of loose monetary policies, bank-credit expansion and rising global commodity prices, could easily recur. Although rapid bank-credit expansion might be less likely in India than in China, India still is at risk from inflation thanks to its much more rigid and constrained supply (that is, production) side.

It will be fascinating to watch. This is the last in my present series of columns for Businessworld, so I will not normally be watching it through BW’s pages in future. But I would like to thank BW’s readers and editors for their support during this series of columns, and wish you great prosperity in coming years.
The author is a former Editor of The Economist.

policyworld dot bw at gmail dot com

(Businessworld Issue Dated 30 June-06 July 2009)

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